Improving the application of and compliance with International Financial

Reporting and Auditing Standards in Trinidad and Tobago. ATN/MT 8114 TT

Guidance notes on International Financial Reporting

Standards (IFRS)

Graham Fairclough

April 2007

Institute of Chartered Accountants of Trinidad and Tobago

Contents Page

IASB Framework 2

IFRS 3: Business Combinations 57

IAS 27: Consolidated and Separate Financial
Statements

IFRS 4: Insurance Contracts 87

Financial Instruments: 104

IAS 32: Presentation
IAS 39: Recognition and Measurement
IFRS 7: Disclosures

IAS 12: Income Taxes 131

IAS 17: Leases 137

IAS 19: Employee Benefits 155

IAS 21: Effects of Foreign Exchange Rates 175

IAS 36 Impairment of Assets 192

IAS 37: Provisions, contingent liabilities and 203

contingent assets

IAS 38: Intangible Assets 220

IAS 40 Investment Property 229

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Chapter 1: Introduction

Purpose and Status

1. This Framework sets out the concepts that

underlie the preparation and presentation of
financial statements for external users. The
purpose of the Framework is to:

• assist the Board of IASC in the development

of future International Accounting Standards
and in its review of existing International
Accounting Standards;

• assist the Board of IASC in promoting

harmonisation of regulations, accounting
standards and procedures relating to the
presentation of financial statements by
providing a basis for reducing the number of
alternative accounting treatments permitted
by International Accounting Standards;

Tutor’s note: IFRS/ IAS has greatly reduced

the number of permitted alternative
• assist national standard-setting bodies in
developing national standards;

Tutor’s note: EU listed companies from

2005 have had to report under IFRS. The
convergence project to harmonise IFRS with
US GAAP is progressing well.

• assist preparers of financial statements in

applying International Accounting Standards
and in dealing with topics that have yet to
form the subject of an International
Accounting Standard;

• assist auditors in forming an opinion as to

whether financial statements conform with
International Accounting Standards;

Tutor’s note: Compliance with IFRS is

effectively the definition of financial
statements that give a true and fair view.
• assist users of Financial statements in
interpreting the information contained in
financial statements prepared in conformity
with International Accounting Standards; and

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 • provide those who are interested in the work
of IASC with information about its approach
to the formulation of International Accounting
Standards.

2. This Framework is not an International Accounting

Standard and hence does not define standards for
any particular measurement or disclosure issue.
Nothing in this Framework overrides any specific
International Accounting Standard.

3. The Board of IASC recognises that in a limited

number of cases there may be a conflict between
the Framework and an International Accounting
Standard. In those cases where there is a conflict,
the requirements of the International Accounting
Standard prevail over those1ASB Framework of
the Framework. As, however, the Board of IASC
will be guided by the Framework in the
development of future Standards and in its review
of existing Standards, the number of cases of
conflict between the Framework and International
Accounting Standards will diminish through time.

Tutor’s note: The instances where this happens

are becoming rarer as IFRS is developed to be
ever more consistent in principles with the

4. The Framework will be revised from time to time

on the basis of the Board'
s experience of working
with it.

Scope

5. The Framework deals with:

• the objective of financial statements;

• the qualitative characteristics that determine

the usefulness. of information in financial
statements;

• the definition, recognition and measurement

of the elements from which financial
statements are constructed; and

• concepts of capital and capital maintenance.

6. The Framework is concerned with general purpose

financial statements (hereafter referred to as
"financial statements") including consolidated
financial statements. Such financial statements are
prepared and presented at least annually and are

3
 directed toward the common information needs of
a wide range of users. Some of these users may
require, and have the power to obtain, information
in addition to that contained in the financial
statements. Many users, however, have to rely on
the financial statements as their major source of
financial information and such financial statements
should, therefore, be prepared and presented with
their needs in view. Special purpose financial
reports, for example, prospectuses and
computations prepared for taxation purposes, are
outside the scope of this Framework.
Nevertheless, the Framework may be applied in
the preparation of such special purpose reports
where their requirements permit.

7. Financial statements form part of the process of

financial reporting. A complete set of financial
statements normally includes a balance sheet, an
income statement, a statement of changes in
financial position (which may be presented in a
variety of ways, for example, as a. statement of
cash flows or a statement of funds flow), and those
notes and other statements and explanatory
material that are an integral part of the financial
statements. They may also include supplementary
schedules and information based on or derived
from, and expected to be read with, such
statements.. Such schedules and supplementary
information may, deal, for example, with financial
information about industrial and geographical
segments and disclosures. about the effects of
changing prices. Financial statements do not,
however, include such items as reports by
directors, statements by the chairman, discussion
and analysis by management and similar items
that may be included in a financial or annual
report.

8. The Framework applies to the financial statements

of all commercial, industrial and business reporting
enterprises, whether in the public or the private
sectors. A reporting enterprise is an enterprise for
which there are users who rely on the financial
statements as their major source of financial
information about the enterprise.

Tutor’s note: There is currently no “IFRS light”

approach to IFRS for smaller and medium sized
entities, although certain standards such as IAS
33 earnings per share are only mandatory for
listed companies. In general though, preparation
of financial statements under IFRS requires
compliance with all IFRS standards. This is seen
4
as making full compliance with IFRS onerous for
all but large or listed companies. A future
IFRSSE (IFRS for smaller entities) may be
Users and Their Information Needs

9. The users of financial statements include present

and potential investors, employees, lenders,
suppliers and other trade creditors, customers,
governments and their agencies and the public.
They use financial statements in order to satisfy
some of their different needs for information.
These needs include the following:

• Investors. The providers of risk capital and

their advisers are concerned with the risk
inherent in, and return provided by, their
investments. They need information to help
them determine whether they should buy,
hold or sell. Shareholders are also interested
in information which enables them to assess
the ability of the enterprise to pay dividends.

Tutor’s note: Investors and investment

analysts are the focus of IFRS. A major aim
of IFRS is to present historical information in
such a way that informed readers of the
information can make intelligent estimates
about future performance of the company.

• Employees. Employees and their

representative groups are interested in
information about the stability and
profitability of their employers. They are also
interested in information which enables them
to assess the ability of the enterprise to
provide remuneration, retirement benefits
and employment opportunities.

• Lenders. Lenders are interested in

information that enables them to determine
whether their loans, and the interest
attaching to them, will be paid when due.

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 • Suppliers and other trade creditors.
Suppliers and other creditors are interested
in information that ' enables them to
determine whether amounts owing to them
will be paid when due. Trade creditors are
likely to be interested in an enterprise over a
shorter period than lenders unless they are
dependent upon the continuation of the
enterprise as a major customer.

• Customers. Customers have an interest in

information about the continuance of an
enterprise, especially when they have a
long-term involvement with, or are
dependent on, the enterprise.

• Governments and their agencies.

Governments and their agencies are
interested in the allocation of resources and,
therefore, the activities of enterprises. They
also require information in order to regulate
the activities of enterprises, determine
taxation policies and as the basis for national
income and similar statistics.

• Public. Enterprises affect members of the

public in a variety of ways. For example,
enterprises may make a substantial
contribution to the local economy in many
ways including the number of people they
employ and their patronage of local
suppliers. Financial statements may assist
the public by providing information about the
trends and recent developments in the
prosperity of the enterprise and the range of
its activities.

10. While all of the information needs of these users

cannot be met by financial statements, there are
needs which are common to all users. As investors
are providers of risk capital to the enterprise, the
provision of financial statements that meet their
needs will also meet most of the needs of other
users that financial statements can satisfy.

Tutor’s note: In practice, companies may publish

multiple financial statements for different important
user groups, perhaps including:

• Financial statements under IFRS

• 6 local GAAP;
Financial statements under
• Tax returns using tax accounting rules
• A published reconciliation between the
11. The management of an enterprise has the primary
responsibility for the preparation and presentation
of the financial statements of the enterprise.
Management is also interested in the information
contained in the financial statements even though
it has access to additional management and
financial information that helps it carry out its
planning, decision making and control
responsibilities. Management has the ability to
determine the form and content of such additional
information in order to meet its own needs. The
reporting of such information, however, is beyond
the scope of this Framework. Nevertheless,
published financial statements are based on the
information used by management about the
financial position, performance and changes in
financial position of the enterprise.

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Case Illustration:

EXTRACT FROM THE ANNUAL REPORT OF CSA FOR YEAR ENDED 31.12.02

RECONCILIATION OF RESULTS AND EQUITY TO STATUTORY ACCOUNTS

The following adjustments have been made to the statutory profit in arriving at the result
for the year under International Financial Reporting Standards.

Note 2002 2001

USD ‘000 USD ‘000

Statutory loss for the year under Czech (1,974) (11,932)

GAAP (translated at average rate)

Translation adjustments – depreciation (a) (2,205) (3,885)

Translated statutory loss for the year

IAS adjustments:

Lease adjustments:

Depreciation (b) (43,790) (41,698)

Finance costs (b) (7,202) (16,995)

Lease expense (b) 70,919 69,555

Aircraft/engine overhaul adjustments (c) 12,546 8,937

Deferred taxation (d) (11,721) 2,275

Other (1,928) 1,577

Profit per International Financial 14,645 7,834

Reporting Standards

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The following are the accumulated adjustments made to the statutory equity in arriving at
the equity for the year under International Financial Reporting Standards.

Note 2002 2001

USD USD ‘000

‘000

Closing equity per statutory accounts 60,383 67,496

(translated at closing rate)

Lease adjustments:

Depreciation of leased aircraft (b) (322,880) (282,850)

Finance lease costs (b) (110,346) (103,144)

Elimination of lease charges (b) 512,728 441,809

Overhaul cost adjustments (note 13)

Capitalised overhaul costs (c) 18,712 15,413

Depreciation of capitalized overhaul costs (c) (9,820) (6,060)

Elimination of provisions for overhaul costs (c) 52,588 41,077

Deferred taxation (note 26) (d) (30,822) (22,449)

Gain on available-for-sale financial assets (9,395) 9,395

(note 35)

Loss on cash flow hedges (interest rate 3,736 (3,736)

swap) (note 35)

Other (13,273) (12,326)

Total adjustment 91,228 77,129

Closing equity per International 151,611 144,625

Financial Reporting Standards

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(a) Depreciation adjustments

The main adjustments required in preparing IFRS financial statements

denominated in US dollars is to restate depreciation on assets acquired in
the past in Czech Crowns to reflect depreciation at historic rates. In the
current year, the Company has implemented an asset register in Oracle to
record US dollar values for all property, plant and equipment, based on the
exchange rates at the historic date of acquisition.

(b) Finance leases

Under Czech accounting standards, finance leases are generally accounted

for as operating leases. The total cost of the rental obligations is charged
to the income statement so as to produce a constant periodic rate of charge
(note-prepayments and accruals are raised to account for deposit payments
and changes in instalment amounts over the period of the lease). The
asset is captialised in the accounts of the lessor. The lessee does not
account for the fixed asset until full legal title is acquired.

Under IFRS, assets held under leasing arrangements that substantially

transfer risks and rewards of ownership, are capitalized and depreciated
over their expected useful lives. The present value of the related obligation
is included in the long and short-term liabilities as appropriate. The interest
element of the rental obligation is charged to the income statement.

(c) Aircraft overhaul costs

The Czech statutory financial statements include provisions in respect

future overhauls for airframe and aero-engines. These costs are accrued
each year in order to spread the costs over the maintenance cycle period
on a systematic basis.

The Company has applied IAS 37 (‘Provisions, Contingent Liabilities and

Contingent Assets’) that requires that such provisions be eliminated on the
grounds that the Company has no legal or constructive obligation in respect
of these liabilities. Overhaul costs have been capitalized and are being
amortised over the maintenance cycle period on a systematic basis.

(d) Deferred taxation

The Czech statutory financial statements include deferred tax balances in

respect of certain taxable temporary timing differences.

Under IFRS, deferred tax liabilities are provided on all taxable temporary
timing differences, and deferred tax assets are recognized for all deductible
temporary differences to the extent that it is probable that taxable profit will
be available against which the deductible temporary difference can be
utilized.

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Case illustration

Extract from the 2005 financial statements of BP Amoco

The extract below demonstrates how companies may present whatevere financial
information they believe that their users will find useful, so long as this
supplementary information is not given a higher profile in the financial statements
than the IFRS accounts. It is normal practice where additional information is
provided to reconcile it to the IFRS figures. It is currently a requirement of any
company listed in the USA that reports under IFRS that although IFRS figures can
be presented as the primary basis of corporate reporting, these figures must be
reconciled fully to US GAAP figures. The SEC’s requirement for this reconciliation
looks likely to be withdrawn in the next few years.

11
Chapter 2: The Objective of Financial Statements

12. The objective of financial statements is to provide

information about the financial position,
performance and changes in financial position of
an enterprise that is useful to a wide, range of
users in making economic decisions.

13. Financial statements prepared for this purpose

meet the common needs of most users. However,
financial statements do not provide all the
information that users may need to make
economic decisions since they largely portray the
financial effects of past events and do not
necessarily provide non-financial information.

14. Financial statements also show the results of the

stewardship of management, or the accountability
of management for the resources entrusted to it.
Those users who wish to assess the stewardship
or accountability of management do so in order
that they may make economic decisions; these
decisions may include, for example, whether to
hold or sell their investment in the enterprise or
whether to reappoint or replace the management.

Financial Position, Performance and Changes in

Financial Position

15. The economic decisions that are taken by users of

financial statements require an evaluation of the
ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their
generation. This ability ultimately determines, for
example, the capacity of an enterprise to pay its
employees and suppliers, meet interest payments,
repay loans and make distributions to its owners.
Users are better able to evaluate this ability to
generate cash and cash equivalents if they are
provided with information that focuses on the
financial position, performance and changes in
financial position of an enterprise.

16. The financial position of an enterprise is affected

by the economic resources it controls, its financial
structure, its liquidity and solvency, and its
capacity to adapt to changes in the environment in
which it operates. Information about the economic
resources controlled by the enterprise and its
capacity in the past to modify these resources is
useful in predicting the ability of the enterprise to
generate cash and cash equivalents in the future.
Information about financial structure is useful in
predicting future borrowing needs and how future

12
 profits and cash flows will be distributed among
those with an interest in the enterprise; it is also
useful in predicting how successful the enterprise
is likely to be in raising further finance. Information
about liquidity and solvency is useful in predicting
the ability of the enterprise to meet its financial
commitments as they fall due. Liquidity refers to
the availability of cash in the near future after
taking account of financial commitments over this
period. Solvency refers to the availability of cash
over the longer term to meet financial
commitments as they fall due

17. Information about the performance of an

enterprise, in particular its profitability, is required
in order to assess potential changes in the
economic resources that it is likely to control in the
future. Information about variability of performance
is important in this respect. Information about
performance is useful in predicting the capacity of
the enterprise to generate cash flows from its
existing resource base. It is also useful in forming
judgements about the effectiveness with which the
enterprise might employ additional resources.

18. Information concerning changes in the financial

position of an enterprise is useful in order to
assess its investing, financing and operating
activities during the reporting period. This
information is useful in providing the user with a
basis to assess the ability of the enterprise to
generate cash and cash equivalents and the
needs of the enterprise to utilise those cash flows.
In constructing a statement of changes in financial
position, funds can be defined in various ways,
such as all financial resources, working capital,
liquid assets or cash. No attempt is made in this
Framework to specify a definition of funds.

19. Information about financial position is primarily

provided in a balance sheet. Information about
performance is primarily provided in an income
statement. Information about changes in financial
position is provided in the financial statements by
means of a separate statement.

20. The component parts of the financial statements

interrelate because they reflect different aspects of
the same transactions or other events. Although
each statement provides information that is
different from the others, none is likely to serve
only a single purpose or provide all the information
necessary for particular needs of users. For
example, an income statement provides an
incomplete picture of performance unless it is used

13
 in conjunction with the balance sheet and the
statement of changes in financial position.

Notes and Supplementary Schedules

21. The financial statements also contain notes and

supplementary schedules and other information.
For example, they may contain additional
information that is relevant to the needs of users
about the items in the balance sheet and income
statement. They may include disclosures about the
risks and uncertainties affecting the enterprise and
any resources and obligations not recognised in
the balance sheet (such as mineral reserves).
Information about geographical and industry
segments and the effect on the enterprise of
changing prices may also be provided in the form
of supplementary information.

Case Illustration

The financial statements of British Airways also include the following

supplementary information which is not governed by IFRS but is recognised by
IFRS as being useful to investors:

14
15
Chapter 3: Underlying Assumptions

Tutor’s note: These principles are so fundamental

under IFRS that companies are not required to state
that they have followed them - it is simply assumed.

Accrual Basis

22. In order to meet their objectives, financial

statements are prepared on the accrual basis of
accounting. Under this basis, the effects of
transactions and other events are recognised
when they occur (and not as cash or its equivalent
is received or paid) and they are recorded in the
accounting records and reported in the financial
statements of the periods to which they relate.
Financial statements prepared on the accrual
basis inform users not only of past transactions
involving the payment and receipt of cash but also
of obligations to pay cash in the future and of
resources that represent cash to be received in the
future. Hence, they provide the type of information
about past transactions and other events that is
most useful to users in making economic
decisions.

Tutor’s note: The accruals concept is also known as

the matching concept also. It involves two things:

• Matching amounts received or paid to the

period they are due (eg. An insurance
premium is treated as an expense in the period
when it is used up, not when it’s paid) and
• Matching costs as far as reasonably possible
to the revenues they generate/are expected to
generate.

In many cases, applying the generally accepted

principles of prudence and matching may yield
different results. In these circumstances, the matching

16
Going Concern

23. The financial statements are normally prepared on

the assumption that an enterprise is a going
concern and will continue in operation for the
foreseeable future. Hence, it is assumed that the
enterprise has neither the intention nor the need to
liquidate or curtail materially the scale of its
operations; if such an intention or need exists, the
financial statements may have to be prepared on a
different basis and, if so, the basis used is
disclosed.

Tutor’s note: The financial statements will look very

different if the accounts are produced on a break-up
basis.

CASE ILLUSTRATION 1:
Accruals

A company purchases an asset at the start of 2001.

For tax purposes, it is to be written off immediately as
an expense, as this is the tax rule.
The management of the company believes that it will
bring benefits to the company for a period of
approximately 5 years, when it will be sold for scrap at
approximately 24% of its purchase price. The
company observes that the machine requires much
more maintenance in the later years than the earlier
years.

Required:

Suggest an accounting treatment in order to best

match costs and revenues.

17
 CASE ILLUSTRATION 2: Accruals

A business holds inventory, which it sells at an average

price of $200 per unit.

The inventory count at the start of the year showed 130

units of inventory with an average cost to the company
of $150 each. During the year, 4,200 units were
purchased at a price of $170 each and 4,010 units were
sold at the expected price.
The year-end stock count showed 230 units were held
by the company.

Required:

Estimate profit for the year.

Suggested solution

Sales revenue ($200 x 4,010) 802,000

Less: Cost of sales

Opening inventory (130 x $150) 19,500
Purchases (4,200 x $170) 714,000
Less: Closing inventory (230 x
$170) -39,100

-
Total cost of sales 694,400

Gross profit 107,600

This familiar method of calculating cost of sales is an

application of the matching principle. The cost of
inventory purchased but not sold (ie not matched to
revenue) is deferred as an asset in the balance sheet in
order to match it to the future revenues.

18
Chapter 4: Qualitative Characteristics of Financial
Statements

24. Qualitative characteristics are the attributes that

make the information provided in financial
statements useful to users. The four principal
qualitative characteristics are understandability,
relevance, reliability and comparability.

Understandability

25. An essential quality of the information provided in

financial statements is that it is readily
understandable by users. For this purpose, users
are assumed to have a reasonable knowledge of
business and economic activities and accounting
and a willingness to study the information with
reasonable diligence. However, information about
complex matters that should be included in the
financial statements because of its relevance to
the economic decision-making needs of users
should not be excluded merely on the grounds that
it may be too difficult for certain users to
understand.

Relevance

26. To be useful, information must be relevant to the

decision-making needs of users. Information has
the quality of relevance when it influences the
economic decisions of users by helping them
evaluate past, present or future- events or
confirming, or correcting, their past evaluations.

27. The predictive and confirmatory roles of

information are interrelated. For example,
information about the current level and structure of
asset holdings has value to users when they
endeavour to predict the ability of the enterprise to
take advantage of opportunities and its ability to
react to adverse situations. The same information
plays a confirmatory role in respect of past
predictions about, for example, the way in which
the enterprise would be structured or the outcome
of planned operations.

19
28. Information about financial position and past
performance is frequently used as the basis for
predicting future financial position and
performance and other matters in which users are
directly interested, such as dividend and wage
payments,, security price movements and the
ability of the enterprise to meet its commitments as
they fall due. To have predictive value, information
need not be in the form. of an explicit forecast. The
ability to make predictions from financial
statements is enhanced, however, by the manner
in which information on past transactions and
events is displayed. For example, the predictive
value of the income statement is enhanced if
unusual, abnormal and infrequent items of income
or expense are separately disclosed.

Tutor’s note: A number of IFRS/ IAS standards

have their focus on presenting historical
information in a way that maximizes its predictive
value. This is discussed further below.

Materiality

29. The relevance of information is affected by its

nature and materiality. In some cases, the nature
of information alone is sufficient to determine its
relevance. For example, the reporting of a new
segment may affect the assessment of the risks
and opportunities facing the enterprise irrespective
of the materiality of the results achieved by the
new segment in the reporting period. In other
cases, both the nature and materiality are
important, for example, the amounts of inventories
held in each of the main categories that are
appropriate to the business.

30. Information is material if its omission or

misstatement could influence the economic
decisions of users taken on the basis of the
financial statements. Materiality depends on the
size of the item or error judged in the particular
circumstances of its omission or misstatement.
Thus, materiality provides a threshold or cut-off
point rather than being a primary qualitative
characteristic which information must have if it is to
be useful.

Tutor’s note: Materiality is of key importance to an

auditor as an immaterial error or omission does
not affect the truth and fairness20
of the financial
statements. IFRS is intended to be applied to all
transactions, even if they are immaterial but any
such non-compliance would not necessarily result
Reliability

31. To be useful, information must also be reliable.

Information has the quality of reliability when it is
free from material error and bias and can be
depended upon by users to represent faithfully that
which it either purports to represent or could
reasonably be expected to represent.

32. Information may be relevant but so unreliable in

nature or representation that its recognition may
be potentially misleading. For example, if the
validity and amount of a claim for damages under
a legal action are disputed, it may be inappropriate
for the enterprise to recognise the full amount of
the claim in the balance sheet, although it may be
appropriate to disclose the amount and
circumstances of the claim.

Tutor’s note: Paragraph 32 is a description of the rare situation of a contingent

liability. A contingent liability exists where a business has an obligation to pay
some money, but has not way of making a meaningful/reliable estimate of how
much will be payable. In virtually all cases, an estimate can be made, although
nobody expects it to be entirely accurate. Even a highly imperfect estimate is
seen to be better than no estimate.

Tutor’s note: Predictive value

Investors make decisions to buy (or hold) a shared based on that share’s
expected future performance, ie profits of the entity. Past performance is not
directly relevant.
21 the need for reliable information and
There is an inevitable conflict between
relevant information in what investors are looking for in financial information.
Tutor’s note

A number of IAS and IFRS standards deal with the disclosures required to make
historical information as relevant as possible to the reader (ie maximise its predictive
value), including:

22
Standard Shows

IAS 8 Extraordinary items

Fundamental errors

Effect of changing accounting policies

Each of these items is expected to have a one-off effect or profit

affecting only this year.

IAS 10 Gives information on significant events after the balance sheet date
that may affect the user’s opinion.

IAS 14 Shows where a company is deriving its revenues and profits, so

investors can assess sensitivity to market changes.

IAS 24 Related party disclosures

Shows where the figures should be taken with a dose of skepticism,

since they may not be at true market value.

IFRS 5 Where a company has closed down a major business segment in the
year, so the profits or losses from that segment will not arise in the
future.

23
Case Study: Usefulness of segment information under IAS 14

BRITISH AIRWAYS OR CSA?

Extracts from recent segment analyses of British Airways and CSA in their published
financial statement prepared under IFRS:

BRITISH AIRWAYS: YEAR ENDED 31 MARCH 2006

Geographical analysis of turnover

Turnover
By area of original sale
GBP million 2006 2005

Europe 5,406 5,079

United Kingdom 4,169 3,906
Continental Europe 1,237 1,173
The Americas 1,611 1,364
Africa, Middle East & Indian sub-continent 826 747
Far East and Australasia 672 582
Total 8,515 7,772

CSA CZECH AIRLINES: YEAR ENDED 31 DECEMBER 2005

Geographical segments
Segment revenue by geographical area (based on location of customer) is as
follows:
USD ‘000 2005 2004

Czech Republic 300,171 236,486

Western Europe 341,713 303,829
Eastern Europe 122,209 94,648
Middle East 46,962 41,735
USA and Canada 84,652 68,564
Total Revenues 895,707 745,262

Required:

Discuss how an investor or investment analyst might make use of the above segment
information when deciding in which airline to invest in 2007. What information does this reveal
about risks and each company’s strategy? Would any further breakdown be useful to analysts?

24
 Tutor’s note: Below is an extract of some of the segment
information given by BP Amoco in its 2005 annual report and
accounts. The depth of information provided to readers of IFRS
accounts to enable users to make informed predictions about the
company’s past and likely future performance can be enormous.

Faithful Representation

33. To be reliable, information must represent faithfully

the transactions and other events it either purports
to represent or could reasonably be expected to
represent. Thus, for example, a balance sheet
should represent faithfully the transactions and
other events that result in assets, liabilities and
equity of the enterprise at the reporting date which
meet the recognition criteria.

34. Most financial information is subject to some risk of

being less than a faithful representation of that
which it purports to portray. This is not due to bias,

25
 but rather to inherent difficulties either in identifying
the transactions and other events to be measured
or in devising and applying measurement and
presentation techniques that can convey
messages that correspond with those transactions
and events. In certain cases, the measurement of
the financial effects of items could be so uncertain
that enterprises generally would not recognise
them in the financial statements; for example,
although most enterprises generate goodwill
internally over time, it is usually difficult to identify
or measure that goodwill reliably. In other cases,
however, it may be relevant to recognise items and
to disclose the risk of error surrounding their
recognition and measurement.

Substance over form

35. If information is to represent faithfully the

transactions and other events that it purports to
represent, it is necessary that they are accounted
for and presented in accordance with their
substance and economic reality and not merely
their legal form. The substance of transactions or
other events is not always consistent with that
which is apparent from their legal or contrived
form. For example, an enterprise may dispose of
an asset to another party in such a way that the
documentation purports to pass legal ownership to
that party; nevertheless, agreements may exist
that ensure that the enterprise continues to enjoy
the future economic benefits embodied in the
asset. In such circumstances, the reporting of a
sale would not represent faithfully the transaction
entered into (if indeed there was a transaction).

Tutor’s note: The principle of reporting substance over

form is crucial to understanding IAS accounting
techniques. Oddly for something of such fundamental
important and pervasive influence there is no IAS or
IFRS specifically that deals with the issue of reporting
commercial substance over form. The Framework
document is the only place where this principle is
elaborated specifically.

26
Consignment inventories

• This is an arrangement where inventories

are held by one party (eg. a distributor) but
are owned by another party (for example a
manufacturer or a finance company).
Consignment inventories are common in
the motor trade and is similar to goods sold
on a ‘sale or return’ basis.

• To identify the correct treatment, it is

necessary to identify the point at which the
distributor acquired the benefits of the asset
(the inventory item) rather than the point at
which legal title was acquired. If the
manufacturer has the right to require the
return of the inventories, and if that right is
likely to be exercised, then the inventories
are not assets of the dealer. If the dealer is
rarely required to return the inventories,
then this part of the transaction will have
little commercial effect in practice and
should be ignored for accounting purposes.
The potential liability would need to be
disclosed in the accounts.

27
Case Illustration

Rover Co owns a number of car dealerships throughout Paris. The terms

of the arrangement between dealership and manufacturer are as follows.

• Legal title passes when the cars are either used by Rover Co for
demonstration purposes or sold to a third party.
• The price of vehicles is fixed at the date of transfer.
• Rover Co has no right to return vehicles
• Rover Co pays a finance charge between delivery and the date
that legal title passes.

Required

(i) What are the risks inherent in holding inventories?

(ii) What features of the arrangement indicate risk?
(iii) On the basis of the above how should Rover Co account for the
transaction?

Sale and repurchase transactions

• These are arrangements under which the

company sells an asset to another person on
terms that allow the company to repurchase the
assets in certain circumstances. The key
question is whether the transaction is a
straightforward sale, or whether it is, in effect, a
secured loan. It is necessary to look at the
arrangement to determine who has the rights to
the economic benefits that the asset generates,
and the terms on which the asset is to be
repurchased.

• If the seller has the right to the benefits of the

use of the asset, and the repurchase terms are
such that the repurchase is likely to take place,
the transaction should be accounted for as a
loan.

28
Case Illustration

X Co are brandy distillers. They normally hold inventories for 6 years before
selling it.
A large quantity of 2 year old inventories have been sold to a bank at cost. The
normal selling price is cost + 100% profit. X Co has an option to buy back the
brandy in 4 years time at a price which represents the original sale price plus
interest at current market rates.

Required

Outline the principle features of the transaction and how it should be dealt with in
the books of X Co in order to provide the most relevant and reliable information
to the shareholders of X Co.

Factoring of debts

• Where debts are factored, the original creditor

sells the debts to the factor. The sales price
may be fixed at the outset or may be adjusted
later. It is also common for the factor to offer a
credit facility that allows the seller to draw upon
a proportion of the amounts owed.

• In order to determine the correct accounting

treatment it is necessary to consider whether
the benefit of the debts has been passed on to
the factor, or whether the factor is, in effect,
providing a loan on the security of the debtors.
If the seller has to pay interest on the difference
between the amounts advanced to him and the
amounts that the factor has received, and if the
seller bears the risk of non-payment by the
debtor, then the indications would be that the
transaction is, in effect, a loan.

Case Illustration

Apple Co sells all of its trade receivables to Factor Co, the terms of the
arrangement being as follows:
29
• Factor Co administers the sale ledger of Apple Co charging 1%
of factored debts.
30
Neutrality

36. To be reliable, the information contained in

financial statements must be neutral, that is, free
from bias. Financial statements are not neutral if,
by the selection or presentation of information,
they influence the making of a decision or
judgement in order to achieve a predetermined
result or outcome.

Prudence

37. The preparers of financial statements do, however,

have to contend with the uncertainties that
inevitably surround many events and
circumstances, such as the collectability of
doubtful receivables, the probable useful life of
plant and equipment and the number of warranty
claims that may occur. Such uncertainties are
recognised by the disclosure of their nature and
extent and by the exercise of prudence in the
preparation of the financial statements. Prudence
is the inclusion of a degree of caution in the
exercise of the judgements needed in making the
estimates required under conditions of uncertainty,
such that assets or income are not overstated and
liabilities or expenses are not understated.
However, the exercise of prudence does not allow,
for example, the creation of hidden reserves or
excessive provisions, the deliberate
understatement of assets or income, or the
deliberate overstatement of liabilities or expenses,
because the financial statements would not be
neutral and, therefore, not have the quality of
reliability.

Completeness

38. To be reliable, the information in financial

statements must be complete within the bounds of
materiality and cost. An omission can cause
information to be false or misleading and thus
unreliable and deficient in tem-is of its relevance.

Comparability

39. Users must be able to compare the financial

statements of an enterprise through time in order
to identify trends in its financial position and
performance. Users must also be able to compare
the financial statements of different enterprises in
order to evaluate their relative financial position,

31
 performance and changes in financial position.
Hence, the measurement and display of the
financial effect of like transactions and other
events must be carried out in a consistent way
throughout an enterprise and over time for that
enterprise and in a consistent way for different
enterprises.

40. An important implication of the qualitative

characteristic of comparability is that users be
informed of the accounting policies employed in
the preparation of the financial statements, any
changes in those policies and the effects of such
changes. Users need to be able to identify
differences between the accounting policies for like
transactions and other events used by the same
enterprise from. period to period and by different
enterprises. Compliance with International
Accounting Standards, including the disclosure of
the accounting policies used by the enterprise,
helps to achieve comparability.

41. The need for comparability should not be confused

with mere uniformity and should not be allowed to
become an impediment to the introduction of
improved accounting standards. It is not
appropriate for an enterprise to continue
accounting in the same manner for a transaction or
other event if the policy, adopted is not in keeping
with the qualitative characteristics of relevance and
reliability. It is also inappropriate for an enterprise
to leave its accounting policies unchanged when
more relevant and reliable alternatives exist.

Tutor’s note: Under IFRS, companies are allowed

a degree over their choice of accounting policies.
For example, each company chooses an
appropriate rate to change depreciation in order to
most fairly apply the matching principle. The need
to charge depreciation itself is not a matter of
choice however.

42. Because users wish to compare the financial

position, performance and changes in financial
position of an enterprise over time, it is important
that the financial statements show corresponding
information for the preceding periods.

32
 Tutor’s note: Companies need to state their
accounting policies in plain language as well as
comparative figures produced under the same
accounting policies. If the accounting policies are
changed in the year the comparative figures need
to be restated using the new accounting policies in
order to ensure that they are comparable.

Constraints on Relevant and Reliable Information

Timeliness

43. If there is undue delay in the reporting of

information it may lose its relevance. Management
may need to balance the relative merits of timely
reporting and the provision of reliable information.
To provide information on a timely basis it may
often be necessary to report before all aspects of a
transaction or other event are known, thus
impairing reliability. Conversely, if reporting is
delayed until all aspects are known, the
information may be highly reliable but of little use
to users who have had to make decisions in the
interim. In achieving a balance between relevance
and reliability, the overriding consideration is how
best to satisfy the economic decision-making
needs of users.

Balance between Benefit and Cost

44. The balance between benefit and cost is a

pervasive constraint rather than a qualitative
characteristic. The benefits derived from
information should exceed the cost of providing it.
The evaluation of benefits and costs is, however,
substantially a judgmental process. Furthermore,
the costs do not necessarily fall on those users
who enjoy the benefits. Benefits may also be
enjoyed by users other than those for whom the
information is prepared; for example, the provision
of further information to lenders may reduce the
borrowing costs of an enterprise. For these
reasons, it is difficult to apply a cost-benefit test in
any particular case. Nevertheless, standard setters
in particular, as well as the preparers and users of
financial statements, should be aware of this
constraint.

33
Balance between Qualitative Characteristics

45. In practice a balancing, or trade-off, between

qualitative characteristics is often necessary.
Generally the aim is to achieve an appropriate
balance among the characteristics in order to meet
the objective of financial statements. The relative
importance of the characteristics in different cases
is a matter of professional judgment.

True and Fair View/Fair Presentation

46. Financial statements are frequently described as

showing a true and fair view of, or as presenting
fairly, the financial position, performance and
changes in financial position of an enterprise.
Although this Framework does not deal directly
with such concepts, the application of the principal
qualitative characteristics and of appropriate
accounting standards normally results in financial
statements that convey what is generally
understood as a true and fair view of, or as
presenting fairly such information.

Tutors’s note: In most legislatures, compliance with

IFRS will automatically be considered to be a true and
fair presentation.

34
Chapter 5: The Elements of Financial Statements

47. Financial statements portray the financial effects of

transactions and other events by grouping them
into broad classes according to their economic
characteristics. These broad classes are termed
the elements of financial statements. The elements
directly related to the measurement of financial
position in the balance sheet are assets, liabilities
and equity. The elements directly related to the
measurement of performance in the income
statement are income and expenses. The
statement of changes in financial position usually
reflects income statement elements and changes
in balance sheet elements; accordingly, this
Framework identifies no elements that are unique
to this statement.

48. The presentation of these elements in the balance

sheet and the income statement involves a
process of sub-classification. For example, assets
and liabilities may be classified by their nature or
function in the business of the enterprise in order
to display information in the manner most useful to
users for purposes of making economic decisions.

Financial Position

49. The elements directly related to the measurement

of financial position are assets, liabilities and
equity. These are defined as follows:

• An asset is a resource controlled by the

enterprise as a result of past events and
from which future economic benefits are
expected to flow to the enterprise.

• A liability is a present obligation of the

enterprise arising from past events, the
settlement of which is expected to result in
an outflow from the enterprise of resources
embodying economic benefits.

Tutor’s note: An obligation is an unavoidable

obligation to act in a certain way whether that
obligation is legally enforceable or just
commercially unavoidable.

• Equity is the residual interest in the assets of

the enterprise after deducting all its liabilities.

35
50. The definitions of an asset and a liability identify
their essential features but do not attempt to
specify the criteria that need to be met before they
are recognised in the balance sheet. Thus, the
definitions embrace items that are not recognised
as assets or liabilities in the balance sheet
because they do not satisfy the criteria for
recognition discussed in paragraphs 82 to 98. In
particular, the expectation that future economic
benefits will flow to or from an enterprise must be
sufficiently certain to meet the probability criterion
in paragraph 83 before an asset or liability is
recognised.

51. In assessing whether an item meets the definition

of an asset, liability or equity, attention needs to be
given to its underlying substance and economic
reality and not merely its legal form. Thus, for
example, in the case of finance leases the
substance and economic reality are that the lessee
acquires the economic, benefits of the use of the
leased asset for the major part of its useful life in
return for entering into an obligation to pay for that
right an amount approximating to the fair value of
the asset and the related finance charge. Hence,
the finance lease gives rise to items that satisfy the
definition of an asset and a liability and are
recognised as such in the lessee' s balance sheet.

Tutor’s note: Lease accounting is under review by the

IASB in order to make it more consistent with the
Framework principles concerning recognition and
presentation of liabilities.

52. Balance sheets drawn up in accordance with

current International Accounting Standards may
include items that do not satisfy the definitions of
an asset or liability and are not shown as part of
equity. The definitions set out in paragraph 49 will,
however, underlie future reviews of existing
International Accounting Standards and the
formulation of further Standards.

Assets

53. The future economic benefit embodied in an asset

is the potential to contribute, directly or indirectly,
to the flow of cash and cash equivalents to the
enterprise. The potential may be a productive one
that is part of the operating activities of the
enterprise. It may also take the form of
convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when

36
 an alternative manufacturing process lowers the
costs of production.

54. An enterprise usually employs its assets to

produce goods or services capable of satisfying
the wants or needs of customers; because these
goods or services can satisfy these wants or
needs, customers are prepared to pay for them
and hence contribute to the cash flow of the
enterprise. Cash itself renders a service to the
enterprise because of its command over other
resources.

55. The future economic benefits embodied in an

asset may flow to the enterprise in a number of
ways. For example, an asset may be:

• used singly or in combination with other

assets in the production of goods or services
to be sold by the enterprise;

• exchanged for other assets;

• used to settle a liability; or

• distributed to the owners of the enterprise.

56. Many assets, for example, property, plant and

equipment, have a physical form. However,
physical form is not essential to the existence of an
asset; hence patents-and copyrights, for example,
are assets if future economic benefits are
expected to flow from them to the enterprise and if
they are controlled by the enterprise.

57. Many assets, for example, receivables and

property, are associated with legal rights, including
the right of ownership. In determining the
existence of an asset, the right of ownership is not
essential; thus, for example, property held on a
lease is an asset if the enterprise controls the
benefits which are expected to flow from the
property. Although the capacity of an enterprise to
control benefits is usually the result of legal rights,
an item may nonetheless satisfy the definition of
an asset even when there is no legal control. For
example, know-how obtained from a development
activity may meet the definition of an asset when,
by keeping that know-how secret, an enterprise
controls the benefits that are expected to flow from
it.

58. The assets of an enterprise result from past

transactions or other past events. Enterprises

37
 normally obtain assets by purchasing or producing
them, but other transactions or events may
generate assets; examples include property
received by an enterprise from government as part
of a programme to encourage economic growth in
an area and the discovery of mineral deposits.
Transactions or events expected to occur in the
future do not in themselves give rise to assets;
hence, for example, an intention to purchase
inventory does not, of itself, meet the definition of
an asset.

59. There is a close association between incurring

expenditure and generating assets but the two do
not necessarily coincide. Hence, when an
enterprise incurs expenditure, this may provide
evidence that future economic benefits were
sought but is not conclusive proof that an item
satisfying the definition of an asset has been
obtained. Similarly the absence of a related
expenditure does not preclude an item from
satisfying the definition of an asset and thus
becoming a candidate for recognition in the
balance sheet; for example, items that have been
donated to the enterprise may satisfy the definition
of an asset.

CASE STUDY

Discuss which of the following meet the definition of asset

above:

• A new aircraft leased for 20 years by an airline;

• 1,000 copies of wall calendars from the previous
year
• A right to produce drugs under a patent.

Liabilities

60. An essential characteristic of a liability is that the

enterprise has a present obligation. An obligation
is a duty or responsibility to act or perform in, a
certain way. Obligations may be legally
enforceable as a consequence of a binding
contract or statutory requirement. This is normally
the case, for example, with amounts payable for
goods and services received. Obligations also
arise, however, from normal business practice,
custom and a desire to maintain good business
relations or act in an equitable manner. If, for
example, an enterprise decides as a matter of
policy to rectify faults in its products even when

38
 these become apparent after the warranty period
has expired, the amounts that are expected to be
expended in respect of goods already sold are
liabilities.

61. A distinction needs to be drawn between a present

obligation and a future commitment. A decision by
the management of an enterprise to acquire assets
in the future does not, of itself, give rise to a
present obligation. An obligation normally arises
only when the asset is delivered or the enterprise
enters into an irrevocable agreement to acquire
the asset. In the latter case, the irrevocable nature
of the agreement means that the economic
consequences of failing to honour the obligation,
for example, because of the existence of a
substantial penalty, leave the enterprise with little,
if any, discretion to avoid the outflow of resources
to another party.

Tutor’s note: Historically, prudence has been used

to make unnecessary provisions in years with good
profits in order to smooth profits as provisions
would then be released to reduce expenses in
years with poorer profits. This is now made
impossible by the definition of a provision as a
liability and the incorporation of the above
62. The settlement of a present obligation usually
involves the enterprise giving up resources
embodying economic benefits in order to satisfy
the claim of the other party. Settlement of a
present obligation may occur in a number of ways,
for example, by:

• payment of cash;

• transfer of other assets;

• provision of services;

• replacement of that obligation with another

obligation; or

• conversion of the obligation to equity

• An obligation may also be extinguished by

other means, such as a creditor waiving or
forfeiting its rights.

63. Liabilities result from past transactions or other

past events. Thus, for example, the acquisition of
goods and the use of services give rise to trade
payables (unless paid for in advance or on

39
 delivery) and the receipt of a bank loan results in
an obligation to repay the loan. An enterprise may
also recognise future rebates based on annual
purchases by customers as liabilities; in this case,
the sale of the goods in the past is the transaction
that gives rise to the liability.

64. Some liabilities can be measured only by using a

substantial degree of estimation. Some enterprises
describe these liabilities as provisions. In some
countries, such provisions are not regarded as
liabilities because the concept of a liability is
defined narrowly so as to include only amounts
that can be established without the need to make
estimates. The definition of a liability in paragraph
49 follows a broader approach. Thus, when a
provision involves a present obligation and
satisfies the rest of the definition, it is a liability
even if the amount has to be estimated. Examples
include provisions for payments to be made under
existing warranties and provisions to cover
pension obligations.

CASE STUDY

Decide, with reasons, which of the following represent a

liability and how that liability should be valued.

• A firm intention to purchase some agricultural

equipment
• An airline’s aircraft fleet being due for an expensive
major service in one year
• A claim on an insurance policy incurred but not
reported;
• The balance on an airline’s frequent flyer program
where customers are promised free flights above a
certain balance;
• A lease signed by a company to lease some machinery
for five years, with onerous penalties for early
Equity

65. Although equity is defined in paragraph 49 as a

residual, it may be sub-classified in the balance
sheet. For example, in a corporate enterprise,
funds contributed by shareholders, retained
earnings, reserves representing appropriations of
retained earnings and reserves representing
capital maintenance adjustments may be shown
separately. Such classifications can be relevant to
the decision-making needs of the users of financial
statements when they indicate legal or other
restrictions on the ability of the enterprise to

40
 distribute or otherwise apply its equity. They may
also reflect the fact that parties with ownership
interests in an enterprise have differing rights in
relation to the receipt of dividends or the
repayment of capital.

66. The creation of reserves is sometimes required by

statute or other law in order to give the enterprise
and its creditors an added measure of protection
from the effects of losses. Other reserves may be
established if national tax law grants exemptions
from, or reductions in, taxation liabilities when
transfers to such reserves are made. The
existence and size of these legal, statutory and tax
reserves is information that can be relevant to the
decision-making needs of users. Transfers to such
reserves are appropriations of retained earnings
rather than expenses.

67. The amount at which equity is shown in the

balance sheet is dependent on the measurement
of assets and liabilities. Normally, the aggregate
amount of equity only by coincidence corresponds
with the aggregate market value of the shares of
the enterprise or the sum that could be raised by
disposing of either the net assets on a piecemeal
basis or the enterprise as a whole on a going
concern basis.

68. Commercial, industrial and business activities are

often undertaken by means of enterprises such as
sole proprietorships, partnerships and trusts and
various types of government business
undertakings. The legal and regulatory framework
for such enterprises is often different from that
applying to corporate enterprises. For example,
there may be few, if any restrictions on the
distribution to owners or other beneficiaries of
amounts included in equity. Nevertheless, the
definition of equity and the other aspects of this
Framework that deal with equity are appropriate
for such enterprises.

Performance

69. Profit is frequently used as a measure of

performance or as the basis for other measures,
such as return on investment or earnings per
share. The elements directly related to the
measurement of profit are income and expenses.
The recognition and measurement of income and
expenses, and hence profit, depends in part on the
concepts of capital and capital maintenance used
by the enterprise in preparing its financial

41
 statements. These concepts are discussed in
paragraphs 102 to 110.

70. The elements of income and expenses are defined

as follows:

• Income is increases in economic benefits

during the accounting period in the form of
inflows or enhancements of assets or
decreases of liabilities that result in
increases in equity, other than those relating
to contributions from equity participants.

• Expenses are decreases in economic

benefits during the accounting period in the
form of outflows or depletions of assets or
incurrences of liabilities that result in
decreases in equity, other than those relating
to distributions to equity participants.

Tutor’s note: These definitions of expenses and

income illustrate the balance sheet focus of IFRS.
If something increases the assets held by an
investor, it is a gain/ income; if something
decreases assets held by an investor, it is a loss/
expense.

Transactions with shareholders aren’t income or

expense!

Tutor’s note: Transactions with equity holders are not

income or expenditure, since they do not increase or
decrease the assets ultimately controlled by the reader
of the accounts. For example, if a company issues
share capital of $100,000 for cash, it increases the
assets of the business but it decreases the assets
personally held by shareholders by the same amount.
From the perpective of the reader of the accounts
there is therefore no increase or decrease. As the
IFRS accounts (and audit opinions) are addressed to
the shareholders such items are not reported as gains.
Similarly, dividends paid are not an expense in the
income statement but are instead reported in the
statement of changes in equity.

71. The definitions of income and expenses identify

their essential features but do not attempt to
specify the criteria that would need to be met
before they are recognised in the income
statement. Criteria for the recognition of income

42
 and expenses are discussed in paragraphs 82 to
98.

72. Income and expenses may be presented in the

income statement in different ways so as to
provide information that is relevant for economic
decision-making. For example, it is common
practice to distinguish between those items of
income and expenses that arise in the course of
the ordinary activities of the enterprise and those
that do not. This distinction is made on the basis
that the source of an item is relevant in evaluating
the ability of the enterprise to generate cash and
cash equivalents in the future; for example,
incidental activities such as the disposal of a long-
term investment are unlikely to recur on a regular
basis. When distinguishing between items in this
way consideration needs to be given to the nature
of the enterprise and its operations. Items that
arise from the ordinary activities of one enterprise
may be unusual in respect of another.

73. Distinguishing between items of income and

expense and combining them in different ways
also permits several measures of enterprise
performance to be displayed. These have differing
degrees of inclusiveness. For example, the income
statement could display gross margin, profit from
ordinary activities before taxation, profit from
ordinary activities after taxation, and net profit.

Income

74. The definition of income encompasses both

revenue and gains. Revenue arises in the course
of the ordinary activities of an enterprise and is
referred to by a variety of different names including
sales, fees, interest, dividends, royalties and rent.

75. Gains represent other items that meet the

definition of income and may, or may not, arise in
the course of the ordinary activities of an
enterprise. Gains represent increases in economic
benefits and as such are no different in nature
from revenue. Hence, they are not regarded as
constituting a separate element in this Framework.

76. Gains include, for example, those arising on the

disposal of non-current assets. The definition of
income also includes unrealised gains; for
example, those arising on the revaluation of
marketable securities and those resulting from
increases in the carrying amount of long term
assets. When gains are recognised in the income
statement, they are usually displayed separately

43
 because knowledge of them is useful for the
purpose of making economic decisions. Gains are
often reported net of related expenses.

77. Various kinds of assets may be received or

enhanced by income; examples include cash,
receivables and goods and services received in
exchange for goods and services supplied. Income
may also result from the settlement of liabilities.
For example, an enterprise may provide goods
and services to a lender in settlement of an
obligation to repay an outstanding loan.

Tutor’s note: Summary of gains, income and revenue.

Expenses

78. The definition of expenses encompasses losses as

well as those expenses that arise in the course of
the ordinary activities of the enterprise. Expenses
that arise in the course of the ordinary activities of
the enterprise include, for example, cost of sales,
wages and depreciation. They usually take the
form of an outflow or depletion of assets such as
cash and cash equivalents, inventory, property,
plant and equipment.

79. Losses represent other items that meet the

definition of expenses and may, or may not, arise
in the course of the ordinary activities of the
enterprise. Losses represent decreases in
economic benefits and as such they are no
different in nature from other expenses. Hence,
they are not regarded as a separate element in
this Framework.

80. Losses include, for example, those resulting from

disasters such as fire and flood, as well as those
arising on the disposal of non-current assets. The
definition of expenses also includes unrealised
losses, for example, those arising from the effects
of increases in the rate of exchange for a foreign

44
 currency in respect of the borrowings of an
enterprise in that currency. When losses are
recognised in the income statement, they are
usually displayed separately because knowledge
of them is useful for the purpose of making
economic decisions. Losses are often reported net
of related income.

Tutor’s note: Total expenses

Case Study

Consider which of the following are likely to be classified as

expenses under IAS rules:

• Fines levied on a company for environmental damage

caused by waste from a factory
• The suffering caused to local communities from this
pollution.

Capital Maintenance Adjustments

81. The revaluation or restatement of assets and

liabilities gives rise to increases or decreases in
equity. While these increases or decreases meet
the definition of income and expenses, they are
not included in the income statement under certain
concepts of capital maintenance. Instead these
items are included in equity as capital
maintenance adjustments or revaluation reserves.
These concepts of capital maintenance are
discussed in paragraphs 102 to 110 of this
Framework.

45
 Tutor’s note: Capital maintenance adjustments are
unlikely to be relevant to any company operating in a
country where inflation is less than 100% in any three year
period. This is the requirement of IAS 29. Adjusting
accounts to remove the distorting effects of inflation has
been a highly controversial area in accounting for years.

Chapter 6: Recognition of the Elements of Financial

Statements

46
82. Recognition is the process of incorporating in the
balance sheet or income statement an item that
meets the definition of an element and satisfies the
criteria for recognition set out in paragraph 83. It
involves the depiction of the item in words and by
a monetary amount and the inclusion of that
amount in the balance sheet or income statement
totals. Items that satisfy the recognition criteria
should be recognised in the balance sheet or
income statement. The failure to recognise such
items is not rectified by disclosure of the
accounting policies used nor by notes or
explanatory material.

83. An item that meets the definition of an element

should be recognised if:

• it is probable that any future economic

benefit associated with the item will flow to or
from the enterprise; and

• the item has a cost or value that can be

measured with reliability.

84. In assessing whether an item meets these criteria

and therefore qualifies for recognition in the
financial statements, regard needs to be given to
the materiality considerations discussed in
paragraphs 29 and 30. The interrelationship
between the elements means that an item that
meets the definition and recognition criteria for a
particular element, for example, an asset,
automatically requires the recognition of another
element, for example, income or a liability.

The Probability of Future Economic Benefit

85. The concept of probability is used in the

recognition criteria to refer to the degree of
uncertainty that the future economic benefits
associated with the item will flow to or from the
enterprise. The concept is in keeping with the
uncertainty that characterises the environment in
which an enterprise operates. Assessments of the
degree of uncertainty attaching to the flow of future
economic benefits are made on the basis of the
evidence available when the financial statements
are prepared. For example, when it is probable
that a receivable owed by an enterprise will be
paid, it is then justifiable, in the absence of any
evidence to the contrary, to recognise the
receivable as an asset. For a large population of
receivables, however, some degree of non-
payment is normally considered probable; hence

47
 an expense representing the expected reduction in
economic benefits is recognised.

Case Study

A company purchased a machine on 1 January 2001, with an

expected life of 10 years and no scrap value. The machine cost
$140,000. At 31 March 2003, the company observes that the
performance of the asset has been poorer than expected and it is
estimated that the machine will produce only the following
revenues:

2003 2004 2005 2006 2007

21,000 20,000 15,000 10,000 zero

Assuming that the company has a cost of capital of 10%, what is

the amount of the machine’s remaining value that still meets the
definition of an asset at 31 December 2003?

Reliability of Measurement

86. The second criterion for the recognition of an item

is that it possesses a cost or value that can be
measured with reliability as discussed in
paragraphs 31 to 38 of this Framework. In many
cases, cost or value must be estimated; the use of
reasonable estimates is an essential part of the
preparation of financial statements and does not
undermine their reliability. When, however, a
reasonable estimate cannot be made the item is
not recognised in the balance sheet or income
statement. For example, the expected proceeds
from a lawsuit may meet the definitions of both an
asset and income as well as the probability
criterion for recognition; however, if it is not
possible for the claim to be measured reliably, it
should not be recognised as an asset or as
income; the existence of the claim, however, would
be disclosed in the notes, explanatory material or
supplementary schedules.

87. An item that, at a particular point in time, fails to

meet the recognition criteria in paragraph 83 may
qualify for recognition at a later date as a result of
subsequent circumstances or events.

88. An item that possesses the essential

characteristics of an element but fails to meet the
criteria for recognition may nonetheless warrant
disclosure in the notes, explanatory material or in
supplementary schedules. This is appropriate
when knowledge of the item is considered to be

48
 relevant to the evaluation of the financial position,
performance and changes in financial position of
an enterprise by the users of financial statements.

Recognition of Assets

89. An asset is recognised in the balance sheet when

it is probable that the future economic benefits will
flow to the enterprise and the asset has a cost or
value that can be measured reliably.

90. An asset is not recognised in the balance sheet

when expenditure has been incurred for which it is
considered improbable that economic benefits will
flow to the enterprise beyond the current
accounting period. Instead such a transaction
results in the recognition of an expense in the
income statement. This treatment does not imply
either that the intention of management in incurring
expenditure was other than to generate future
economic benefits for the enterprise or that
management was misguided. The only implication
is that the degree of certainty that economic
benefits will flow to the enterprise beyond the
current accounting period is insufficient to warrant
the recognition of an asset.

Recognition of Liabilities

91. A liability is recognised in the balance sheet when

it is probable that an outflow of resources
embodying economic benefits will result from the
settlement of a present obligation and the amount
at which the settlement will take place can be
measured reliably. In practice, obligations under
contracts that are equally proportionately
unperformed (for example, liabilities for inventory
ordered but not yet received) are generally not
recognised as liabilities in the financial statements.
However, such obligations may meet the definition
of liabilities and, provided the recognition criteria
are met in the particular circumstances, may
qualify for recognition. In such circumstances,
recognition of liabilities entails recognition of
related assets or expenses.

Tutor’s note: These recognition tests arise in many

places throughout IAS and IFRS standards. The only
significant exception is financial instruments which are
recognised as soon as a company49 is contractually
bound to a transaction even if there is no initial gain or
loss.
Recognition of Income

92. Income is recognised in the income statement

when an increase in future economic benefits
related to an increase in an asset or a decrease of
a liability has arisen that can be measured reliably.
This means, in effect, that recognition of income
occurs simultaneously with the recognition of
increases in assets or decreases in liabilities (for
example, the net increase in assets arising on a
sale of goods or services or the decrease in
liabilities arising from the waiver of a debt
payable).

93. The procedures normally adopted in practice for

recognising income, for example, the requirement
that revenue should be earned, are applications of
the recognition criteria in this Framework. Such
procedures are generally directed at restricting the
recognition as income to those items that can be
measured reliably and have a sufficient degree of
certainty.

Tutor’s note: The recognition of income and

expenses is a side effect of the double entry of the
associated asset or liability.

Recognition of Expenses

94. Expenses are recognised in the income statement

when a decrease in future economic benefits
related to a decrease in an asset or an increase of
a liability has arisen that can be measured reliably.
This means, in effect, that recognition of expenses
occurs simultaneously with the recognition of an
increase in liabilities or a decrease in assets (for
example, the accrual of employee entitlements or
the depreciation of equipment).

95. Expenses are recognised in the income statement

on the basis of a direct association between the
costs incurred and the earning of specific items of
income. This process, commonly referred to as the

50
 matching of costs with revenues, involves the
simultaneous or combined recognition of revenues
and expenses that result directly and jointly from
the same transactions or other events; for
example, the various components of expense
making up the cost of goods sold are recognised
at the same time as the income derived from the
sale of the goods. However, the application of the
matching concept under this Framework does not
allow the recognition of items in the balance sheet
which do not meet the definition of assets or
liabilities.

96. When economic benefits are expected to arise

over several accounting periods and the
association with income can only be broadly or
indirectly determined, expenses are recognised in
the income statement on the basis of systematic
and rational allocation procedures. This is often
necessary in recognising the expenses associated
with the using up of assets such as property,
plant, equipment, goodwill, patents and
trademarks; in such cases the expense is referred
to as depreciation or amortisation. These
allocation procedures are intended to recognise
expenses in the accounting periods in which the
economic benefits associated with these items are
consumed or expire.

97. An expense is recognised immediately in the

income statement when an expenditure produces
no future economic benefits or when, and to the
extent that, future economic benefits do not
qualify, or cease to qualify, for recognition in the
balance sheet as an asset.

98. An expense is also recognised in the income

statement in those cases when a liability is
incurred without the recognition of an asset, as
when a liability under a product warranty arises.

51
Chapter 7: Measurement of the Elements of
Financial Statements

99. Measurement is the process of determining the

monetary amounts at which the elements of the
financial statements are to be recognised and
carried in the balance sheet and income
statement. This involves the selection of the
particular basis of measurement.

Tutor’s note: There are still significant differences in

the method used to measure different assets and
liabilities in the financial statements. This is a legacy
of the past rather piecemeal approach to accounting
standard setting. There is a general move towards
reflecting assets in the balance sheet at their fair
values and liabilities at the net present value of the
liability.

100. A number of different measurement bases are

employed to different degrees and in varying
combinations in financial statements. They include
the following:

• Historical cost. Assets are recorded at the

amount of cash or cash equivalents paid or
the fair value of the consideration given to
acquire them at the time of their acquisition.
Liabilities are recorded at the amount of
proceeds received in exchange for the
obligation, or in some circumstances (for
example, income taxes), at the amounts of
cash or cash equivalents expected to be
paid to satisfy the liability m the normal
course of business.

Tutor’s note: This base is common.

• Current cost. Assets are carried at the

amount of cash or cash equivalents that
would have to be paid if the same or an
equivalent asset was acquired currently.
Liabilities are carried at the undiscounted
amount of cash or cash equivalents that
would be required to settle the obligation
currently.

Tutor’s note: This base is rare.

• Realisable (settlement) value. Assets are

carried at the amount of cash or cash

52
 equivalents that could currently be obtained
by selling the asset in an orderly disposal.
Liabilities are carried at their settlement
values; that is, the undiscounted amounts of
cash or cash equivalents expected to be
paid to satisfy the liabilities in the normal
course of business.

• Present value. Assets are carried at the

present discounted value of the future net
cash inflows that the item is expected to
generate in the normal course of business.
Liabilities are carried at the present
discounted value of the future net cash
outflows that are expected to be required to,
settle the liabilities in the normal course of
business.

Tutor’s note: This base is increasingly

common. It is the prescribed method for
many provisions and financial liabilities such
as loans.

101. The measurement basis most commonly adopted

by enterprises in preparing their financial
statements is historical cost. This is usually
combined with other measurement bases. For
example, inventories are usually carried at the
lower of cost and net realisable value, marketable
securities may be carried at market value and
pension liabilities are carried at their present value.
Furthermore, some enterprises use the current
cost basis as a response to the inability of the
historical cost accounting model to deal with the
effects of changing prices of non. monetary assets.

53
Chapter 8: Concepts of Capital and Capital
Maintenance

Tutor’s note: This principle is related to inflation

accounting. It is an important principle but one that is
not particularly controversial or likely to change in the
short-term. It is included here for completeness’ sake.
In virtually all cases, nominal financial capital
maintenance is the chosen capital maintenance
concept in IFRS. This means that if the balance sheet
total increases, even if this is just by inflation, then a
gain will be reported.

Concepts of Capital

102. A financial concept of capital is adopted by most

enterprises in preparing their financial statements.
Under a financial concept of capital, such as
invested money or invested purchasing power,
capital is synonymous with the net assets or equity
of the enterprise. Under a physical concept of
capital, such as operating capability, capital is
regarded as the productive capacity of the
enterprise based on, for example, units of output
per day.

103. The selection of the appropriate concept of capital

by an enterprise should be based on the needs of
the users of its financial statements. Thus, a
financial concept of capital should be adopted if
the users of financial statements are primarily
concerned with the maintenance of nominal
invested capital or the purchasing power of
invested capital. If, however, the main concern of
users is with the operating capability of the
enterprise, a physical concept of capital should be
used. The concept chosen indicates the goal to be
attained in determining profit, even though there
may be some measurement difficulties in making
the concept operational.

Concepts of Capital Maintenance and the

Determination of Profit

104. The concepts of capital in paragraph 102 give rise

to the following concepts of capital maintenance:

• Financial capital maintenance. Under this

concept a profit is earned only if the financial
(or money) amount of the net assets at the
end of the period exceeds the financial (or
money) amount of net assets at the

54
 beginning of the period, after excluding any
distributions to, and contributions from,
owners during the period. Financial capital
maintenance can be measured in either
nominal monetary units or units of constant
purchasing power.

• Physical capital maintenance. Under this

concept a profit is earned only if the physical
productive capacity (or operating capability)
of the enterprise (or the resources or funds
needed to achieve that capacity) at the end
of the period exceeds the physical
productive capacity at the beginning of the
period, after excluding any distributions to,
and contributions from, owners during the
period.

105. The concept of capital maintenance is concerned

with how an enterprise defines the capital that it
seeks to maintain. It provides the linkage between
the concepts of capital and the concepts of profit
because it provides the point of reference by which
profit is measured; it is a prerequisite for
distinguishing between an enterprise' s return on
capital and its return of capital; only inflows of
assets in excess of amounts needed to maintain
capital may be regarded as profit and therefore as
a return on capital. Hence, profit is the residual
amount that remains after expenses (including
capital maintenance adjustments, where
appropriate) have been deducted from income. If
expenses exceed income the residual amount is a
net loss.

106. The physical capital maintenance concept requires

the adoption of the current cost basis of
measurement. The financial capital maintenance
concept, however, does not require the use of a
particular basis of measurement. Selection of the
basis under this concept is dependent on the type
of financial capital that the enterprise is seeking to
maintain.

107. The principal difference between the two concepts

of capital maintenance is the treatment of the
effects of changes in the prices of assets and
liabilities of the enterprise. In general terms, an
enterprise has maintained its capital if it has as
much capital at the end of the period as it had at
the beginning of the period. Any amount over and
above that required to maintain the capital at the
beginning of the period is profit.

55
108. Under the concept of financial capital maintenance
where capital is defined in terms of nominal
monetary units, profit represents the increase in
nominal money capital over the period. Thus,
increases in the prices of assets held over the
period, conventionally referred to as holding gains,
are, conceptually, profits. They may not be
recognised as such, however, until the assets are
disposed of in an exchange transaction. When the
concept of financial capital maintenance is defined
in terms of constant purchasing power units, profit
represents the increase in invested purchasing
power over the period. Thus, only that part of the
increase in the prices of assets that exceeds the
increase in the general level of prices is regarded
as profit. The rest of the increase is treated as a
capital maintenance adjustment and, hence, as
part of equity.

109. Under the concept of physical capital maintenance

when capital is defined in tem-is of the physical
productive capacity, profit represents the increase
in that capital over the period. All price changes
affecting the assets and liabilities of the enterprise
are viewed as changes in the measurement of the
physical productive capacity of the enterprise;
hence they are treated as capital maintenance
adjustments that are part of equity and not as
profit.

110. The selection of the measurement bases and

concept of capital maintenance will determine the
accounting model used in the preparation of the
financial statements. Different accounting models
exhibit different degrees of relevance and reliability
and, as in other areas, management must seek a
balance between relevance and reliability. This
Framework is applicable to a range of accounting
models and provides guidance on preparing and
presenting the financial statements constructed
under the chosen model. At the present time, it is
not the intention of the Board of IASC to prescribe
a particular model other than in exceptional
circumstances, such ' as for those enterprises
reporting in the currency of a hyperinflationary
economy. This intention will, however, be reviewed
in the light of world developments.

56
IFRS 3: Business Combinations
IAS 27: Consolidated and Separate Financial
Statements

This chapter deals initially with the accounting for a new business
combination, together with methods used to calculate goodwill.
There is a substantial practical overlap between IFRS 3/ IAS 27 and
the following accounting standards:

IAS 21: Foreign currency (where an acquired company is abroad)

IAS 28: Investments in Associates
IAS 31: Interests in Joint Ventures
IAS 36: Impairment of Assets
IAS 38: Intangible Assets

These standards are covered in outline through this chapter and an

outline of their key requirements is given at the end of this chapter.
This outline is not a complete description of these additional
standards and you should make reference to the full IFRS/ IAS as
necessary.

The need for the standard

It is very common for larger companies to trade as a group of

companies. Rather than have all activities in one company, a large
company may set up or acquire subsidiary companies. This may
enable more efficient tax planning, may be necessary where
activities are outside the parent company’s own country and a host
of other resaons.

The investor in the parent company does not personally pay any
consideration for the interest in these subsidiary companies. Rather
the parent pays its own resources to either set up the subsidiary
company (in the case of organic growth) or pays consideration to
the previous owners of a new subsidiary (in the case of acquisitive
growth).

Investor

Parent company

Subsidiary company

Traditionally there had been two methods of accounting for when a

parent obtains control of a subsidiary: the purchase method (also
known as the acquisition method) or the merger method (also

57
known as the uniting of interests method). The merger method had
the effect of presenting figures that appeared to be better and there
was no need to calculate any premium for acquiring control. IFRS 3
prohibits the use of the merger method for any new business
combination. This is to prevent abuse of the previous provisions of
merger accounting and to recognise that true mergers, ie where
neither party is dominant over the other, are sufficiently rare to be
irrelevant.

Framework focus
The Framework definition of an asset is a
resource controlled by an entity, not necessarily
owned by that entity. So although the
shareholder in the parent company does not
legally own the shares in the subsidiary, these
investors control that subsidiary and thus all the
subsidiary’s assets and liabilities. The individual
assets and liabilities of the subsidiary should
therefore be recognised in the parent company’s
financial statements.
This is also a further application of the principle of reporting
commercial substance over legal form.

Requirements of the standard

IFRS 3 requires that for all new business combinations (being any
transaction that confers the ability of one company to control
another), the following should be determined:

• Which company is the acquirer and which is the acquired

• Measure the cost of the combination to the acquirer (this will

be more relevant where an acquirer buys a pre-existing
business than when it sets up a new legal entity as a
subsidiary company)

• Determine the fair values of each of the identifiable assets

and liabilities of the acquired company

• Determine the premium for control, ie goodwill, as the

difference between the fair value of consideration paid to
acquire control less the fair value of net assets acquired

• Prepare consolidated, ie group, financial statements in

addition to the parent’s individual financial statements for
each reporting period after the combination. This involves
eliminating any intra-group transactions as these are
effectively a single economic entity trading with itself.

• If the subsidiary is subsequently disposed of, cease to

consolidate the financial statements from the date that

58
 control of the subsidiary is lost by the parent. Recognise a
gain or loss on derecognition of the subsidiary.

These notes attempt to explain group accounting by following an

imaginary transaction through each of these stages.

59
Identification of control (IAS 27 paragraphs 12-21)

A subsidiary is an entity, including unincorporated business entities

such as partnerships, that is under the control of the parent
company. It is not necessary to have more than 50% of the voting
shares in a company to be that company’s parent, although this is
the normal way of obtaining control.

Case study 3.1

Beatles Co owns 55% of the voting shares in Abbey Co. Abbey Co

owns 55% of the voting shares in Road Co. Road Co owns 25% of
the voting shares in Zebra Co.

Required

Identify, with reasons, which of the above companies is a

subsidiary of Beatles Co.

Solution to case study 3.1

This provides a chain of control to Beatles Co. Beatles Co owns

55% of Abbey Co, which gives Beatles Co control of Abbey. This
makes Abbey a subsidiary of Beatles. In turn, Abbey has 55% of
the shares in Road Co, giving Abbey control of Road. This makes
Road a subsidiary of Abbey. As Abbey is itself a subsidiary of
Beatles, Road is also a subsidiary (a sub-subsidiary) of Beatles.

Road’s 25% of Zebra can be presumed to give Road significant

influence in Zebra, making Zebra an associate of Road. Since
Road is ultimately controlled by Beatles, Beatles has the ability to
use this significant influence, making Zebra an associate of
Beatles.

Case study 3.2

Highrisk Bank Co is the legal owner of one $1 share in SPE Co.

SPE Co owns only one asset, which is a factory with a value of $5
million. It also has a loan from Highrisk Bank Co of $4,999,999.

SPE is managed by Neveron Co, which charges SPE a

management fee equal to all the profits of SPE Co, including
payment of interest to Highrisk Bank Co at market rates. SPE Co
has also given a call option to Neveron Co so that Neveron can
purchase the factory for $5 million at any time. Neveron Co has
granted SPE Co a put option that can require Neveron Co to buy
the factory from Neveron Co for $5 million at any time.

Required

60
Identify the principal characteristics of the above agreement. State
which is the parent and subsidiary relationship and why.

Solution to case study 3.2

SPE is an unusual company, since it is entirely managed by

Neveron Co, but is actually legally owned by Highrisk Bank Co. It
is almost totally financed by debt, with only a nominal share capital.

Theonly asset of SPE is the factory, which is currently managed by

Neveron and which will certainly eventually revert to Neveron,
given the parallel existence of the put and call options. The put
option means that if the value of the factory should fall, the bank
would exercise their put option, meaning that ownership would
revert to Neveron. Similarly, if the value should greatly increase,
Neveron would exercise its call option to regain ownership of the
factory. Applying the Framework criteria for control and
recognition, Neveron should continue to recognise the factory on
its balance sheet.

SPE is simply a vehicle that provides security for a loan to

Neveron. In the event that Neveron should go bankrupt, Highrisk
Bank can claim its security since it is the legal owner of SPE and
its assets. However, in substance over form, Neveron controls
SPE and all its assets.

So despite the fact that Neveron owns none of the equity capital in
SPE, Neveron should continue to consolidate SPE as its
subsidiary, including a secured loan from Highrisk Bank.

Identification of acquirer and acquired (IFRS 3 paragraphs 17 –

23)

No matter how much companies may wish to present their business

combinations to the world as a merger, IFRS 3 requires that in all
circumstances an acquirer is identified. The acquirer is the
company that has the ability to exercise control over the other and
the moment of acquisition is when this ability to possibly exercise
control occurs. This is even if the actual exercise of control comes
later or if the legal formalities are not completed for some time after
the ability to exercise control is conferred.

In some circumstances, it may not be obvious which party is the

acquirer and which is acquired. These are the rare situations where
a business combination has characteristics close to a true merger.
The acquirer is likely to:

• Have the higher market capitalisation

• Pay the greater amount of cash to effect the combination

61
 • Dominate the new combined management team

Where a combination happens by an exchange of equity, the

acquirer is more likely to be the issuer of the new equity
instruments.

Case study 3.3

Tiddler and Bloater are two companies in the same market sector.
They announce that they have been in merger negotiations for some
time. The board of Bloater makes a recommendation to its
shareholders that the shareholders should vote to accept the
following offer, with which the directors of Tiddler had approached
the directors of Bloater some months previously:

• Tiddler will issue to the current shareholders of Bloater five

shares in Tiddler for each four shares that the shareholders
currently hold in Bloater. Immediately before the offer,
Bloater had 310 million shares in issue with a market value of
$2.11 each and Tiddler had 125 million shares with a market
value of $1.85 each.

• The name of Tiddler will be changed to Tiddler Bloater

Corporation immediately after the merger.

• Tiddler will pay the necessary professional fees in cash to

affect the merger.

• The new board will be made up roughly equally of directors

from each company. The chief executive of Tiddler will
become the chief executive of the new merged entity. The
other roles will be decided after the deal is completed but it is
agreed that the board other than the chief executive should
be initially made up equally from managers from each legacy
company.

The offer was accepted by 92% of the shareholders of Bloater in a

general meeting on 14 September, although the actual share issue
was not completed until 19 November.

Required

Discuss the features of the above transaction and decide which

company is the acquirer and why. What date should be treated as
the acquisition date?

62
Solution to case study 3.3

Factors that suggest Bloater should be treated as the acquirer:

Bloater’s market capitalisation before the announcement is much

bigger than Tiddler’s ($654.1 million compared to Tiddler’s $231.25
million).

Factors that suggest Tiddler should be treated as the acquirer:

The deal was proposed by the directors of Tiddler to the directors of

Bloater. Tiddler appears to be driving the deal.
Tiddler has undertaken to pay the cash disbursements
The new group chief executive is the CEO of Tiddler
There is an apparent control premium to the current shareholders of
Bloater. Compare the positions of a shareholder of two shares in
Bloater:

Before the offer:

Held 4 shares at a value of $2.11 each

$8.44

After exchanging two shares in Bloater for five in Tiddler:

Holds 5 shares at a value of $1.85 each:

$9.25

Conclusion

This is a reverse takeover, ie where a smaller entity acquires control

of an underperforming larger entity by means of a share for share
exchange. The effective date is 14 September, since the board of
Tiddler will be able to control the activities of Bloater after that date.

Determining cost of acquiring control (IFRS 3 paragraphs 24 –

35)

The guiding principle here is that any consideration given or

promised should be shown at its fair value. Where there is an earn-
out arrangement, which is where the amount to be paid is
determined by the profits of the business acquired after the
acquisition date, a best estimate of the likely consideration to be
paid must be made. The same is true of all other contingent
consideration.

Any amendments to the estimates are treated as an amendment to

the goodwill figure in subsequent years. These adjustments are
treated as a prior period adjustment in accordance with IAS 8. This
requires retrospective restatement of the recognised asset or liability

63
of the acquiree, with a consequential change to the carrying value of
goodwill. (IFRS 3, paragraphs 63 – 64).

Marginal costs incurred by the acquirer to obtain control of the new

subsidiary are also capitalised. Any ongoing costs such as the cost
of the acquirer’s own corporate finance team must be expensed in
full in the period incurred.

Case study 3.4

Company A makes an offer to the shareholders of company B to

acquire control of company B. B is owned by a private equity group
which accepts the following consideration for the sale on 31
December 20x2:

• A will pay $20 million to the current shareholders of B. One

half of that will be paid in cash immediately and one half will
be paid in four years’ time. This element of the consideration
is unconditional.

• An additional payment in cash of 1% of the average turnover

of the next three years will be paid at the end of year four.
The most recent accounts of B show turnover of $700 million,
and this is expected to grow by $50 million in each of the next
three years.

• Investment bank fees of $140,000 were incurred by A as part

of the takeover and it estimates that the cost of time by its
own corporate finance department has been $90,000.

• An additional payment of $500,000 will be paid to the

shareholders of B if B’s average turnover for the next three
years is above $850 million per year. This will be paid in 4
years.

• A also issued new shares in A to give to the current

shareholders of B. Immediately after these shares were
issued, the share price of A was $1.24 - $1.34. 500,000 such
shares were issued. Company A guarantees that if its share
price falls below $1.00 per share within 3 months of the
takeover, it will pay the shareholders of B extra cash to
ensure that their minimum value of the shares they accept
will not fall below $500,000.

Required

Calculate the fair value of consideration given to acquire control of B

at 31 December 20x2.

Case study 3.4 continued

On 31 December 20x3, the following facts emerge:

• Turnover of B has risen to $780 million. It is now expected to

64
 rise to $890 million in the following year then remain stable.

• The share price of B fell after the takeover. Its shares were
trading at $0.88-$0.98 by 31 March 20x3.

Company A uses a discount rate of 5% to discount long-term

liabilities.

Required

Calculate a revised figure for this fair value of consideration at 31

December 20x3 and state how the revised figures should be
presented.

Solution to case study 3.4, part one

$’000

Cash paid now: 10,000

4
Cash in 4 years’ time: $10m x 1/(1.05) 8,227

External investment bank fees 140

Internal expenses 0

Additional fee if turnover > $850m (not expected) 0

Shares issued: $1.24 x 500,000 620

Guaranteed minimum value (per para 35, IFRS 3) 0

Total cost of combination to acquirer 18,987

Solution to case study 3.4, part two

In addition to the figure above, the following payments are expected:

Additional $500,000 if turnover > $850m (now expected)

This is a correction to the initial estimates. It has been discovered

within 12 months of the control date so in accordance with
paragraphs 62 et seq of IFRS 3, it will be treated as a prior period
error in accordance with IAS 8. This means that goodwill is
recalculated as if this figure had been known at the time.

This will generate retrospective recognition of a further liability of:

$500,000 x 1/(1.05)4 = $411,351

Dr Goodwill initially recognised $411,351

65
Cr Provisions $411,351.

Determining the fair value of net assets acquired (IFRS 3

paragraphs 36 – 50)

The amount that an acquirer pays to acquire control of a business is

inevitably going to be the figure that both buyer and seller agree
represents a fair value for the business as a going concern. In
deciding how much to pay to acquire control of the business, the
acquirer will make their own estimation of the fair value of the
target’s assets and liabilities. On top of this will be a premium for
control of the acquired company and its expected future profits.

It is highly unlikely that the acquired company’s balance sheet value

of individual assets and liabilities will represent their fair value. For
example, IAS 2 inventories requires that inventory is valued at the
lower of cost and net realisable value. This means that if the value
of inventory has increased since it was bought by the target
company, this will not be reflected in the balance sheet of the target
company.

Case study 3.5

Imagine a simplified scenario where company B has only long-term

inventory such as whisky that requires ten years to mature. The
historic cost of producing this was $50,000 but as it is almost ready
for sale it could be sold to another company at an arm’s length value
of $200,000.

If this company were to be acquired by company A, company A

would actually be buying only some long-term inventory. However if
there were no need to revalue to fair values, the figure for goodwill
would be grossly overstated:

With fair values Without

Fair value of consideration $200,000 $200,000

Less: Net assets acquired ($200,000) ($50,000)

Goodwill 0 $150,000

To avoid holding gains erroneously overstating the value of goodwill

it is therefore necessary to revalue individual assets and liabilities of
a target company to fair values. This also includes placing a value
on contingent liabilities. Although the rules of IAS 37 normally
forbids recording a contingent liability in the balance sheet, the
existence of a contingent liability would very probably reduce the
amount of consideration that a buyer would be willing to pay for the
acquired company.

66
Fair values often have the effect of changing the post-acquisition
profits of the new group of companies. For example in case study
3.3 above if the inventory were to be sold immediately after the
acquisition of company B for $220,000 this would report a group
profit of $20,000. Without a fair value adjustment, it would report a
group profit of $170,000.

On the acquisition, it is necessary to look at each of the acquired

company’s assets and liabilities and assign a fair value to them.
The identifiable assets of the acquired company are all the assets
and liabilities of the acquired company other than goodwill. This
may include intangible assets if it is possible to identify a fair value
for these intangible assets, which will normally only be possible if
there is a reliable market value for the intangible asset. This is rare.
As explained in the notes on IAS 37 provisions, it cannot include
any provisions for any future intentions of the acquirer since these
do not represent an obligating event.

Case study 3.6 (continuation of case study 3.4 above)

Company A acquires company. At the date of acquisition, the

summary balance sheet of company B shows the following:

Balance sheet Fair

values

$’000s $’000s

Tangible non-current assets 9,000 14,000

Intangible non-current assets 1,900 see below

Inventory 2,100 2,300

Receivables 3,200 3,200

Bank balances and cash 700 700

Current liabilities & provisions (2,200) (2,200)

Non-current liabilities (3,200) (3,200)

Deferred tax liability (800) (800)

Included within tangible non-current assets of the company are a

number of printing plants that the acquirer does not want, but which
came bundled with the sale. These have a balance sheet value of
$250,000. The acquirer intends discontinuing the printing activities.
The fair value of these assets is $235,000 and it is expected that the
staff will need to be made redundant at a cost of $60,000 although
efforts will be made to find work for them elsewhere in the new
combined business. It is expected to cost $20,000 to sell the

67
surplus printing equipment.

The intangible assets recognised in the balance sheet are deferred

development costs of an unpatented project that is producing profits.
The product is expected to produce profits of at least $1.9 million.

The acquirer believes that the cost of integrating the acquired

business into its own business will be $1.3m. This includes such
matters as replacing corporate logos of B. A also believes that B will
make trading losses of $0.75m in each of the two years after the
acquisition.

At the acquisition date, B was being sued for past pollution damage.
It believes that it is not liable for this pollution although it is
recognised that there is a 30% chance of it being found liable. B
recently turned down an offer from the person suing it to reach an
out-of-court settlement of $0.65m.

Certain senior members of staff at company B had “poison pill” terms

in their contracts stating that if B were to be taken over by another
company they would be paid bonuses of $0.2m and their contracts
would immediately be terminated.

Company B owns a number of brands which it uses to market its

products. It has been estimated internally that the brands generate
an extra $1.2 million each year in profit compared to unbranded
products. It is felt that it would be possible to sell some of these
brands without selling the business of B as a going concern. These
brands are not included in intangible non-current assets in the
balance sheet.

Required

Suggest a fair value to be ascribed to each of the assets listed

above. For simplification, assume that none of the further
adjustments to fair values will affect the deferred tax liability.

Solution to case study 3.6

Assets at fair values:

Per list Adjustments Fair value

Tangible non-current assets 14,000 (35) Note 1 13,965

Intangible non-current assets 1,900 Note 2 1,200 Note 6 3,100

Inventory 2,300 0 2,300

Receivables 3,200 0 3,200

Bank 700 0 700

68
Current liabilities & provisions (2,200) (650) Note 4 (3,050)

(200) Note 5

Non-current liabilities (3,200) 0 (3,200)

Deferred tax (800) 0 (800)

Net assets 16,215

Notes

1. Fair value less costs to sell, per para 36 IFRS 3 is 235 – 20 =

215. This implies an impairment of 35 below current
recognised fair values. The staff redundancies are not highly
probable and are not costs to sell, so are not deducted from
the carrying value of the assets in this disposal group.

2. Development costs do not appear to be impaired. Payment

by the acquirer is evidence of their value. They are not
therefore impaired and can be recognised in full.

3. The intentions to rebrand and reorganise cannot be

recognised as a pre-acquisition provision in the books of the
acquired company. Similarly there is no obligation to trade at
a loss, so no provision can be made.

4. Contingent liabilities normally are only disclosed in the notes

to the financial statements, rather than recognised as a
liability/ provision in the balance sheet. Assuming that
Company B has properly applied IFRS, this means that the
balance sheet of B will need to be amended to include a
value for the contingent liability in order to apply paragraph
37 of IFRS 3 The recent offer to settle the liability at $0.65
million may be a reasonable fair value. Although Company B
rejected this offer (implying it believed its true value to be
less), Company A may wish to settle legacy liabilities of B
quickly. It will therefore increase provisions by up to $0.65
million.

5. The poison pills will crystallise and become a liability in the

event of a takeover. These would not have been in the
balance sheet as there was no liability prior to A’s takeover,
so $0.2 million will need to be added to current liabilities.

6. The brands are separable from Company B’s business

without threatening its going concern status. They may
therefore be recognised as an asset, since Company A’s
payment is evidence of a reliable value. Normally brands are
not recognised as assets as they do not have a reliable
value.

69
Positive Goodwill on Acquisition (IFRS 3 paragraphs 51 – 55)

Goodwill represents the expected future earnings potential of a

business. The extra amount that an acquirer is willing to pay above
the fair value of individual assets and liabilities of a business is
goodwill.

Goodwill is measured at its initial purchase price and is subject to

annual impairment reviews in accordance with IAS 36 Impairment of
Assets. It is therefore shown at its initial purchase cost less
accumulated impairment reviews. It cannot be revalued upwards,
even if circumstances leading to an impairment have reversed.
Goodwill must not be amortised or debited directly to reserves, as
previous accounting standards on goodwill have required.

Case study 3.7

Using the figures from case studies 3.4 (part one) and 3.6, estimate
the goodwill on A’s acquisition of B. Assume that all Company B’s
shareholders accept Company A’s offer to acquire their shares.

Solution to case study 3.7

$’000

Fair value of consideration 18,987

Less: Fair value of identifiable and separable net assets

16,215

Group share x 100%

(16,215)

Goodwill initially recognised 2,772

70
Negative Goodwill on Acquisition (IFRS paragraph 56-57)

If the calculation of goodwill shows a negative figure, this is probably

due to an error being made in the fair value exercise. A
reassessment should be made of each fair value for completeness
and accuracy.

If the fair value exercise shows no errors, then it appears that the
acquirer has simply obtained a bargain in the purchase of the
subsidiary, perhaps because the previous owners were forced to sell
the subsidiary to meet short-term cash flow needs.

If the preparer of the accounts is satisfied that the calculation is

correct yet it has yielded negative goodwill, this negative goodwill
must be recognised immediately as a credit in the income statement.

This situation is rare. By far the most common cause of negative

goodwill is a failure to identify possible contingencies or revalue
assets that are normally required to be shown at historic cost to their
fair values.

Step-by-Step Acquisitions (IFRS 3 paragraphs 58 – 60)

It is common that control is built up through a number of individual

transactions. In such circumstances, the goodwill calculation is
broken into separate components, as the fair values would be
different for each tranche of the equity of the target company
acquired.

Although IFRS 3 doesn’t say so specifically, this would become an

issue from the first tranche of shares that gave the eventual acquirer a
significant influence in the activities of the target, since this would be
the first tranche to require that the target is accounted for as an
associate under IAS 28. Normally, significant influence starts to build
up from when the acquirer owns at least 20% of the voting shares of
the target company.

Case study 3.8

Save Co progressively acquires control of Day Co over a period of

slightly less than a year using the following investments, all of which
are properly measured at fair value:

• 1 December 20x4: Bought 10% of the equity of Day Co at a

cost of $100,000.

• 1 March 20x5: Bought a further 15% of the equity of Day Co

at a cost of $160,000.

71
 • 1 May 20x5: Bought a further 40% of the equity of Day Co at
a cost of $560,000.

• 1 September 20x5: Bought a further 15% of the equity of Day

Co at a cost of $74,000.

The fair values of the identifiable net assets of Day Co on these

dates were:

• 1 December 20x4: $800,000

• 1 March 20x5: $850,000

• 1 May 20x5: $900,000

• 1 September 20x5: $1,100,000.

Both companies have a year-end of 31 December each year.

Required

Assuming that no impairment of goodwill has been identified by 31

December 20x5, show goodwill in the group accounts of the Saves
Co group at that date.

Solution to case study 3.8

The first purchase was for only 10% of the equity of the target
company. This would be presumed not to give significant influence,
so would be accounted for only as a normal trade investment.
Goodwill would not therefore be recorded on this transaction.
However, it would be added to the cumulative cost of acquiring the
first 25% that confers significant influence.

All figures in $'

000s 1 Mar x5 1 May x5 1 Sep x5

Fair value of consideration 260 560 74

FV assets 850 900 1100

Percentage acquired 25% 40% 5%

FV assets acquired (212.5) (360) (55)

Goodwill on this tranche 47.5 200 19

Total goodwill @ 31 Dec

x5 266.5

72
Year-end consolidation

The principal requirements for consolidation of a subsidiary and

parent entity accounts to produce an additional set of consolidated
accounts are:

Necessary task Required by:

There should be a line-by-line consolidation of IAS 27 para 22

each item controlled by the parent in both
group balance sheet and group income
statement. Logically, the income statement is
only consolidated for the period when the
parent had control.

The parent and subsidiary should have IAS 27 para 26 - 27

coterminous year-ends. If the legal entities
don’t have the same year-end, interim
accounts of the subsidiary should be
consolidated.

All group companies should prepare accounts IAS 27 para 28 - 30

for consolidation using uniform accounting
policies.

All intra-group transactions should be fully IAS 27 para 24 - 25

eliminated in preparation of the group
accounts. This may have an effect on
deferred tax as it will amend reported profit but
probably not affect the tax base of each group
company.

An intermediate parent company can avoid the IAS 27 para 10

need to prepare group accounts if it is
consolidated itself into another group reporting
under IFRS, it is not a listed company or
seeking listing and if the intermediate parent
company’s shareholders agree to not receive
group accounts.

If minority interests in the balance sheet are IAS 27 para 33-36

negative, this negative balance should be
allocated to the parent company’s funds
unless there is a legally binding obligation on
the minority to make good any cumulative
losses.

When a parent loses control of a subsidiary, IAS 27 para 31-32

the line-by-line consolidation must end. If the
parent retains any investment in that company,
the value of the net assets of the subsidiary at
the date of losing control becomes the base
cost of the investment under IAS 39.

73
74
Comprehensive example 1
Source: ACCA Diploma in International Financial
Reporting June 2006

On 1 October 2005 Hydan, a publicly listed company, acquired

a 60% controlling interest in Systan paying $9 per share in
cash. Prior to the acquisition Hydan had been experiencing
difficulties with the supply of components that it used in its
manufacturing process. Systan is one of Hydan’s main
suppliers and the acquisition was motivated by the need to
secure supplies. In order to finance an increase in the
production capacity of Systan, Hydan made a non-dated loan
at the date of acquisition of $4 million to Systan that carried an
actual and effective interest rate of 10% per annum. The
interest to 31 March 2006 on this loan has been paid by
Systan and accounted for by both companies. The
summarised draft financial statements of the companies are:

Income statements for the year ended 31 March 2006

Hydan $’000 Systan $’000

pre- post-
acquisition acquisition

Revenue 98,000 24,000 35,200

Cost of sales (76,000) (18,000) (31,000)

Gross profit 22,000 6,000 4,200

Operating expenses (11,800) (1,200) (8,000)

Interest income 350 nil nil

Finance costs (420) nil (200)

Profit/ (loss) before tax 10,130 4,800 (4,000)

Income tax (expense)/ relief (4,200) (1,200) 1,000

Profit/ (loss) for the period 5,930 3,600 (3,000)

75
Balance sheets at 31 March 2006

Hydan $’000 Systan $’000

Non-current assets

Property, plant and equipment 18,400 9,500

Investments 16,000 nil

(including loan to Systan)

34,400 9,500

Current assets 18,000 7,200

Total assets 52,400 16,700

Equity and liabilities

Ordinary shares of $1 each 10,000 2,000

Share premium 5,000 500

Retained earnings 20,000 6,300

35,000 8,800

Non-current liabilities

7% bank loan 6,000 nil

10% loan from Hydan nil 4,000

Current liabilities 11,400 3,900

Total equity and liabilities 52,400 16,700

You are also told the following information:

(i) At the date of acquisition, the fair values of Systan’s

property, plant and equipment were $1·2 million in
excess of their carrying amounts. This will have the effect
of creating an additional depreciation charge (to cost of
sales) of $300,000 in the consolidated financial
statements for the year ended 31 March 2006. Systan
has not adjusted its assets to fair value.

76
(ii) In the post acquisition period Systan’s sales to Hydan
were $30 million on which Systan had made a consistent
profit of 5% of the selling price. Of these goods, $4
million (at selling price to Hydan) were still in the
inventory of Hydan at 31 March 2006. Prior to its
acquisition Systan made all its sales at a uniform gross
profit margin.

(iii) Included in Hydan’s current liabilities is $1 million owing

to Systan. This agreed with Systan’s receivables ledger
balance for Hydan at the year end.

(iv) An impairment review of the consolidated goodwill at 31

March 2006 revealed that its current value was 12·5%
less than its carrying amount.

(v) Neither company paid a dividend in the year to 31 March

2006.

Required:
Prepare the consolidated income statement for the year ended
31 March 2006 and the consolidated balance sheet at that date.

77
Suggested solution to comprehensive example

H's
Income statement consolidation control of Consolidation Consolidation Consolidation
schedule Hydan Systan adjustments adjustments adjustments Consolidated

Revenue 98,000 35,200 (30,000) (W1) 103,200

Cost of sales (76,000) (31,000) 30,000 (W1) (200) (W2) (300) (W3) (77,500)
Gross profit 22,000 4,200 25,700
Operating expenses (11,800) (8,000) (375) (W6) (20,175)
Interest income 350 0 (200) (W4) 150
Finance costs (420) (200) 200 (W4) (420)
Profit/ (loss) before tax 10,130 (4,000) 5,255
Income tax (expense)/ relief (4,200) 1,000 (3,200)
Profit/ (loss) for the period 5,930 (3,000) 2,055

Attributable to: (W10)

Equity holders of the parent (W10)
Minority interests

(W1) The intra-group trading must be removed at its transfer price. Failure to do this would effectively be showing the entity trading with
itself.
(W2) There is an unrealised profit from the intra-group transfer. This must be eliminated since failing to do this would enable groups to
generate profits simply by moving inventory around the group at bogusly inflated values. The goods that have been sold outside the
group are proven profit: only the element remaining needs to be removed. This is $4m x 5% = $200,000.
(W3) The fair value adjustment to non-current assets at acquisition will initially lift the group balance sheet value. This increased balance
sheet value will increase the depreciable amount. This additional depreciation figure is given in the question but will have been
calculated as the additional non-current asset value depreciated using Systan’s depreciation policy.

78
(W4) The intra-group finance charges do not represent transactions between the group and third parties, so must be removed. This doesn’t
affect overall profit as it reduces finance costs and interest income by the same amount. It is calculated as $4m x 10% x 6/12 to show
only the post-acquisition figure, as only post-acquisition figures (those under the control of H) are consolidated.
H' s
Balance sheet consolidation control of Consolidation Consolidation
schedule Hydan Systan adjustments adjustments Consolidated

Non-current assets
Property, plant and equipment 18,400 9,500 1,200 (W5) (300) (W5) 28,800
Goodwill 0 0 3,000 (W6) (375) (W6) 2,625
Investments (including loan to
Systan) 16,000 0 (10,800) (4,000) (W7) 1,200

Current assets 18,000 7,200 (200) (W8) (1,000) (W5) 24,000

Total assets 52,400 16,700 56,625

Equity and liabilities

Ordinary shares of $1 each 10,000 2,000 10,000
Share premium 5,000 500 See workings below 5,000
Retained earnings 20,000 6,300 17,525
Minority interests 3,800

Non-current liabilities
7% bank loan 6,000 0 6,000
10% loan from Hydan 0 4,000 (4,000) (W7) 0
Current liabilities 11,400 3,900 (1,000) (W9) 14,300
Total equity and liabilities 52,400 16,700 56,625

79
(W5) Property, plant and equipment is that of the parent, plus all the property, plant and
equipment of the subsidiary at its recognised value (ie fair value less additional depreciation on
the fair value adjustment). This is $18,400 + 9,500 + (1,200 – 300)) = 28,800

(W6)

Goodwill on acquisition of Systan

1.10.05 Cash (2,000 x 60% x $9) 10,800 1.10.05 Net assets line-by-line (w7) 13,000

1.10.05 Minority interest on acquisition 5,200 1.10.05 => Goodwill on acquisition 3,000

16,000 16,000

1.10.05 B/d 3,000 31.3.06 Impairment loss 375

31.3.06 C/d 2,625

3,000 3,000

(W7) Net assets of Systan at acquisition

Utitling the fact that net assets = equity (by definition) and that equity is capital &
reserves (by definition)

Capital of S 2,000
Share premium of S 500
Reatined profits of S (6,300 + 3,000) 9,300
Fair value adjustments 1,200

13,000

80
Minority @ 40% thereon 5,200

Minority interest (balance sheet)

31.3.06 Share of post-acquisition loss 1,400 1.10.05 On acquisition 5,200

31.3.06 C/d 3,800

5,200 5,200

Note: Minority interest is based on capital and reserves of the subsidiary at the group balance
sheet date. The figure of 3,800 above therefore includes 40% of the retained earnings of S at 31
March 2006.

Retained group earnings

31.3.06 Reserves S x 60% 5,580 1.10.05 Retained earnings of H 20,000

Retained earnings of S x
31.3.06 Extra depreciation x 60% 180 1.10.05 60% 3,780
31.3.06 Unrealised profit x 60% 120
Cumulative godwill
31.03.06 impaired 375
31.3.06 C/d 17,525

23,780 23,780

81
Disposal of group companies

When a parent loses control of its subsidiary, it means that that

the shareholders’ interests will have been depleted, although
some consideration may have been received from the disposal.
This will generate a profit or loss on disposal of the shares in the
subsidiary. This reflects the fact that the gain or loss on disposal
of anything is the difference between the assets newly
recognised in the balance sheet and the net assets
derecognised from the balance sheet. The group income
statement will show a line-by-line consolidation of the
subsidiary’s income statement up until the date of the disposal.

Case study 3.9

Parent has held control of Subsidiary for a number of years

with a 60% interest in the voting shares of the subsidiary
having been purchased by Parent for $1.6 million.

On 1 July 20x4, Parent sold the shares in Subsidiary to

Purchaser Co for consideration of $2.4 million. The
unamortized goodwill relating to the purchase of Subsidiary by
Parent in the group balance sheet at 30 June 20x4 was
$350,000 and the net assets of Subsidiary in the Parent group
balance sheet at that date were $3.4 million.

Required

Calculate the profit or loss on disposal of S in:

• The individual financial statements of Parent Co for the

year ended 31 December 20x4, and

• The group financial statements of the Parent Co group

at 31 December 20x4.

Solution to case study 3.9

Gain in the individual financial statements of Parent Co

The individual accounts of Parent never decomposed the cost of

investment in Subsidiary into the identifiable individual assets of
Subsidiary and goodwill on acquisition. The gain or loss no
disposal is therefore simply:

$’000s
Proceeds (ie net assets newly
2,400
recognised in Parent’s individual financial
statements)

82
Less: Cost of investment (1,600)

Gain on disposal in individual accounts 800

In the group financial statements of Parent Co group:

In the group accounts, the cost of investment is replaced by the

goodwill on the acquisition, less cumulative impairments, plus
each indentifiable asset and liability as a line-by-line
consolidation.

The gain or loss on disposal is therefore different, as different

assets and liabilities are being derecognised in the group
financial statements compared to the individual financial
statements:

$’000s $’000s
Proceeds (ie net assets newly
2,400
recognised in Parent’s individual
financial statements)
Less: Items derecognised from
the group financial statements:

Unimpaired goodwill (350)

Identifiable net assets of S 3,400

at 1 July 20x4

Minority interest at 40% of (1,360)

above

(2,040)

Gain on disposal in the group 10

accounts

Case study 3.10 (continuation of case study 3.9)

Suppose that rather than disposing of the shares in Subsidiary,

Parent had instead sold 10% of its holding to Investor Co for
consideration of $190,000.

Required

Explain how this would be shown in the group financial

statements of the Parent Co group at 31 December 20x4.

83
Solution to case study 3.10

The balance sheet of the Parent group would still consolidate

Subsidiary as Parent would still have control of Subsidiary. This
is because Parent would still own 54% of Subsidiary’s voting
shares.

The minority interest in the balance sheet would be calculated

using a minority interest of 46%.

Income statement

The income statement would include a gain or loss on part

disposal of Subsidiary, effectively the increase in minority
interest:

$’000s
Proceeds (ie net assets newly
190
recognised in Parent’s individual financial
statements)
Less: Derecognised goodwill* ($350,000 (35)
x 10%)

Less: Effective transfer of group assets

to enlarged minority interest

(46% x 3,400) – (40% x 3,400)

(204)

Loss on part disposal in group income (49)

statement

84
Advanced group accounting issues: Group reorganisations
and demergers

Neither IAS 27 nor IFRS 3 deal specifically with the issue of

group reorganisations and demergers. The following is
therefore general best practice, based on a combination of
principles in IAS 27, IFRS 3 and the Framework.

Reorganisations

These may happen where a group benefits from some logical

reordering of its investments. For example, the group below is
an inefficient group for tax purposes:

SHAREHOLDERS

Parent Co (Trinidad and Tobago registered)

Subsidiary A (Registered in Germany)

Subsidiary B (Trinidad and Tobago registered)

In this situation, if one of the Trinidad and Tobago registered

companies is loss making and the other is profit making it may
not be possible to group relieve losses against the profits as the
other as a foreign entity is “in the way”.

A more efficient structure would be:

SHAREHOLDERS

Parent (Trinidad and Tobago registered)

Subsidiary A (Germany) Subsidiary B (T & T)

85
The issue arises in the group accounts of Subsidiary A, since
this company will lose control of subsidiary B and therefore will
need to cease to consolidate it and de-recognise the cost of the
investment in its own entity accounts.

Say that the original cost of A’s investment in B had been $50
million, representing goodwill of $10 million and other net assets
of $40 million. If B had net assets in its balance sheet at the
date of the reorganisation of $54 million, then the necessary
double entries would be:

Individual accounts of A:

Dr Proceeds from disposal (presumably zero) $0

Cr Cost of investment in B $50 million
Dr Loss on derecognition/ disposal $50 million.

Individual accounts of Parent:

Dr Cost of investment in B $50 million

Cr Gain on initial recognition of B $50 million.

In the group accounts of Parent, the cost of investment in B

would be eliminated and replaced instead with goodwill and the
individual net assets of B. The gain in the entity accounts of
Parent would be cancelled by the loss in the entity accounts of
A, showing no group gain or loss overall. This is sensible, as
the shareholders (for whom the accounts are prepared) have
neither lost nor gained anything; they have simply placed a
group company in a different place in the same group.

This situation could be complicated where not all subsidiaries

are fully owned by the parent, since there would be a change in
the minority interest figures.

Demergers

Where a group of companies contains a number of different

activities, especially where the different activities have
significantly different risks and returns there may be pressure to
break up the group and allow investors to decide which activities
they wish to invest in.

For example, a conglomerate telecoms company with activities

in traditional landlines and mobile telephones may demerge into
two separate companies as given below:

BEFORE DEMERGER:

86
 SHAREHOLDERS

Telecom Co

Landline and broadband subsidiary Mobile phones subsidiary

AFTER DEMERGER:

SHAREHOLDERS

Telecom Co

Landline and broadband subsidiary Mobile phones subsidiary

A demerger such as this can be achieved by a number of

means, one of which is for Telecom co to transfer its shares in
the mobile phone subsidiary directly to Telecom Co’s own
shareholders. This means that the shareholders have a new
asset that they gold directly and Telecom Co has lost control of
one of its subsidiaries. The loss of control means that the
demerged subsidiary needs to be derecognised from the group
accounts.

After the demerger, the shareholders can decide to keep their

investment in both operating companies or decide to sell one
part of their holding.

The issue in this scenario is that Telecom Co will dispose of its

subsidiary and so the individual assets and liabilities of the
mobile phones subsidiary will be derecognised from Telecom
Co’s group balance sheet.

As the demerger of the mobile phones subsidiary is normally for

no consideration, this will generate a substantial debit in the
group accounts. It is normal to report this as a debit to reserves
of Telcom Co rather than as a debit to the income statement.
Reporting the derecognition as a loss may be misleading, since
immediate after the demerger the shareholders have not lost an
interest in any assets. An expense would report a depletion of
shareholders’ interests that does not exist.

87
IFRS 4: Insurance Contracts

The need for the standard

IFRS 4 was introduced by the IASB in response to a number of

needs:

• Growing globalisation of the market for investment in

insurance companies
• Growing use of insurance contracts by non-insurance
companies
• Widespread lack of confidence in profits reported by
writers of insurance contracts as unusually large losses
were often inappropriately smoothed by amortising the
cost of past large losses or building up “catastrophe
provisions” for future large losses.
• The lack of international consensus on how to account
for insurance prior to this.

Scope of the standard

There are a number of transactions specifically not within the

scope of IFRS 4, such as weather derivatives which are covered
by IAS 39.

It is critical to note that IFRS 4 covers insurance contracts,

rather than insurance companies. All persons responsible for
corporate reporting should be familiar with IFRS 4’s definition of
insurance risk in order to make sure that they adequately identify
transactions that would be covered by IFRS 4. There are
probably a number of situations where companies unexpectedly
have to apply IFRS 4, despite not being insurance companies.

Some examples of unexpected application or non-application of

IFRS 4 include:

• An insurance company with policies in place that do not

meet the IFRS 4 definition of an insurance contract will
have to be accounted for using different methods to
those prescribed by IFRS 4, and
• Non-insurance companies who sell services or products
that contain a transfer of uncertainties to the company
from the customer may well have to apply IFRS 4. An
example of this is where a company sells extended
warranty agreements over goods.

88
Requirements of IFRS 4

The standard imposes a number of changes to insurance

contracts (which may include non-insurance companies too).. In
particular, it requires:

• Potential exposure to losses on an insurance contract to

be recognised at the inception of an insurance contract.
• Underwriting result to be reported in the year that the
premium is written, essentially as the movement on the
expected claims.that the issuer of an insurance contract
is ever expecting to pay.
• Un-bundling of endowment style policies between
deposit (investment) and life insurance elements.
• The identification and separate accounting for any
derivative features of insurance contracts (eg guaranteed
returns to endowment policy holders).
• Prohibition of all catastrophe and equalisation provisions.

Framework focus: Relevance and

reliability

The IASB Framework document identifies

relevance and reliability as key desirable
features of financial reporting. The
Framework uses certain highly important
definitions in deciding what is both
relevant and reliable:

Asset (IASB Framework)

An asset is a resource controlled by the enterprise as a result of

past events and from which future economic benefits are
expected to flow to the enterprise.

Liability (IASB Framework)

A liability is a present obligation of the enterprise arising from

past events, the settlement of which is expected to result in an
outflow from the enterprise of resources embodying economic
benefits.

Equity (IASB Framework)

Equity is the residual interest in the assets of the enterprise after

deducting all its liabilities.

89
An interim accounting standard

IFRS 4 in its current form is an interim solution. Although it

addresses most of the key matters to accounting for insurance,
there are a number of significant things still left unresolved,
especially the issue of discounting provisions.

A revised standard (“Phase 2” of the project) is expected to be

issued in the next few years. This revised standard will address
the issues around discounting of provisions for future claims,
which are only partially resolved in the existing standard.

Definition of insurance contract (IFRS 4, Appendices A and B)

There is widespread confusion over what actually constitutes an

insurance contract. Its scope may be considerably wider than
many expect.

Insurance contract

A contract under which one party (the insurer) accepts

significant insurance risk from another party (the policyholder) by
agreeing to compensate the policyholder or other beneficiary if a
specified uncertain future event (the insured event) adversely
affects the policyholder or other beneficiary.

Unbundling components of business risk

An individual or a business face a number of different types of

risk, some of which will be transferred by an insurance policy.
The rest will be retained, some of which may be managed by
tactics such as hedging.

Total business
risks

90
Risks
transferred
 Risks retained
by the
business.

Financial risks
Insurance
(see below)
risk
(Non-financial
risks
transferred
from the
policyholder to
the insurer)

Financial risk (IFRS 4, Appendix A)

The risk of a possible future change in one or more of:

• a specified interest rate

• security price

• commodity price

• foreign exchange rate

• index of prices or rates

• a credit rating or credit index, or

• other variable, provided in the case of a non-financial

variable that the variable is not specific to a party to the
contract.

Insurance risk

Risks, other than financial risks, transferred from the holder of a

contract to the issuer.

It is irrelevant what the legal form of the contract is. If, in

substance over form, a contract gives rise to significant transfer

91
of an insurance risk, it is an insurance contract, even if it
describes itself using other terms.

Equally, a contract that describes itself as an insurance contract

but does not substantially transfer an insurance risk is not an
insurance contract.

Interaction with IAS 39

An individual or a company may transfer financial risk by a

number of means, including:

• Foreign currency futures or options

• Commodity futures or options
• Index-linked investments.

It may also manage non-financial risks retained within the

business. For example, it may contract to purchase a weather
derivative if its revenues are significantly weather-dependent.

In each of these cases, the holder of such a contract holds a

derivative, which is accounted for under IAS 39.

92
Case study 4.1

An insurance company offers a number of savings based policies. A

particular savings based policy guarantees a certain level of return of 5%
per year for a fixed period of 10 years.

An investor deposits $1,000 on 1 January 20x0 into this fund, with a

guaranteed 5% return fixed until the fund matures on 31 December
20x9. In the event of the early death of the investor, the contract
provides that the accumulated value of his investment will be repaid, at
its actual value, or its value compounded at 5% if that is higher. This
early redemption does not incur any penalties in the event of death of
the policyholder. If redeemed early, a significant penalty applies.

In effect, both the insurance company and the investor are making a
“bet” that the investments will achieve a return of not less that 5% a
year. As with all bets, one party will win and the other will lose.

Imagine if the actual average compound return over that period were
either 3.5% or 6%. In these circumstances, the value of the fund would
be:

3.5% 6%

Actual (outcome in the “spot” market”) $1,411 $1,791

Guaranteed return given to the investor $1,629 $1,629
Difference $218 $162

To the investor this is a gain loss

This difference is the value of an embedded derivative. For further

details of embedded derivatives, see our notes on IAS 39. This
derivative is not covered by IFRS 4.

The investor is effectively investing $1,000 in the “spot” market, using

actual investment returns. At the same time, he/ she is buying a future,
linked to a 5% compound return. If the actual returns in the period were
3.5%, the investor has transferred this risk of poor returns to the
insurance company by taking a guaranteed return.

This is no tan insurance contract since the death during the policy of the
policyholder only requires the policy to be cashed out at its accumulated
value. The occurrence or non-occurrence of the single event (ie death
of the policyholder) in the period would not cause any actual loss to the
writer of the “insurance” contract. Although it would cause the writer of
the contract to suffer an opportunity loss, since it will not be able to make
a return on the funds invested for as long as expected, an opportunity
loss is not an expense.

93
Case studies 4.2 – 4.10

Decide whether these contracts substantially transfer risk or not.

If so, decide whether they transfer financial risk, insurance risk
or an element of both. Accordingly, state whether each is an
insurance policy, an investment fund or a hybrid.

4.2 A term life cover that is renewed at the start of each year
for a premium set at the start of that year. In the event of
death of the policyholder in the year, a set amount is paid.
If the policyholder survives, nothing is paid to them.

4.3 An endowment fund, with a fixed maturity date. In the

event of death of the policyholder, the valuation of the
policyholder’s investments is paid to their estate, with no
transaction fees, early redemption penalties or
supplements to fund value.

4.4 An endowment fund to repay a household mortgage. The

endowment fund is of a “unit linked” variety, meaning that
the valuation of the fund is decided by the actual
performance of the investments during the period. In the
event of the death of the endowment holder before the 20
year maturity date of the endowment, the insurance
company agrees to pay off the household mortgage
immediately.

4.5 A whole-life “with profits” life insurance policy. The policy

provides for an endowment at a maturity date and a
guaranteed return. In the event of the death of the
policyholder before the maturity date, a lump sum benefit
of twice the accrued value of the policyholder’s fund is
immediately paid. In addition, if investment returns exceed
the guaranteed minimum, the life insurance company may
choose to pay dividends to policyholders each year. This
is at the discretion of the insurance company.

4.6 A funeral director sells funeral pre-need plans. This plan

involves pre-paying funeral expenses during a person’s life
and agreeing what the funeral costs will be. The funeral
director then invests the funds and keeps the return from
the investments. The undertaker agrees to never charge a
surcharge on the membership fee of the plan nor any
adjustment to the cost of delivering the agreed funeral,
even if actual expenses are much higher or lower than
expected.

4.7 A contract agrees to pay a member an annuity every

month from the date of their retirement to the date of their
death. The annuity was purchased for a fixed amount
during a person’s working life.

94
4.8 A manufacturer gives warranties of one year on their
products, offering to repair or replace the goods if they are
faulty.

4.9 A distributor of electrical goods offers to sell “extended

warranties” on goods they sell. In return for a payment at
the time of purchase, the warranty can be extended to
either three or five years. If the goods go wrong, the
distributor either pays the manufacturer to repair them, or
bears the cost of replacement.

4.10 A reinsurance policy, which pays excess of loss benefits to

the insured party (to the “direct insurer”). The policy is for
a period of ten years, and the premium is set each year,
based on the experience of the previous years. If there
are claims, these are paid by the insurer to the insured in
the year that the claim is made, but the premium for the
following year is adjusted to include this amount, plus a
small additional “administration charge”. In the final year,
the premium is retrospectively changed to take into
account claims in that year.

Solutions to case studies 4.2 – 4.10

4.2 This is an insurance risk only, since it is a contract that
transfers a risk that is normally inherent to the buyer of the
policy to the issuer of the policy.

4.3 This is an investment fund only. The amount of the cash

flow is not increased or decreased depending on the death
of the policyholder.

4.4 This is a hybrid of insurance risk and financial risk. The

death of the policyholder is not normally something that
would be a risk assumed by a company, but the contract
transfers the risk of this to the policy issuer, as it has to
write off the loan. This causes a loss as defined in the
IASB Framework. Contrast this with example 4.3 above,
which causes an opportunity loss only to the issuer of the
policy.

4.5 This is a hybrid of insurance risk and financial risk, with

discretionary participation features as well (see further
notes on discretionary participation features below). The
guaranteed return is an embedded derivative per IAS 39.
The issuer has a risk of having to pay double the benefits if
the holder of the contract dies. This puts the issuer of the
policy “on risk” for something they would normally not be
on risk for. This transfer of risk to the issuer of the policy
makes this component of the contract an insurance
contract.

4.6 This is an insurance policy and is one of the examples

95
 given in the standard (paragraph B18, Appendix A, IFRS 4).
Although death is certain, the timing of the death will
potentially cause a loss to the funeral director, as if the
funeral director has to pay for a funeral sooner than
expected, it will generate a loss.

4.7 This is an insurance contract. Normally, the risk of living

longer than a person’s savings last is a risk the person
themselves takes. This contract effectively transfers the
risk of greater longevity than a person’s savings can cover
from the buyer of the policy to the issuer. If the annuity is
sold for a fixed sum but the insured person dies shortly
afterwards, derecognition of the expected liability to pay the
annuity until death from the issuer’s balance sheet will
generate a gain in the income statement of the issuer. As
with 4.6, this contract means the issuer of the contract is
now exposed to making a gain or loss depending on
whether the other person dies in the period. This therefore
is a transfer of insurance risk so this is an insurance
contract.

4.8 This is neither insurance risk nor finance risk, but is normal
business risk. The transaction would be covered by IAS
37. It is a normal feature of business to have to bear the
costs of rectifying or replacing defective goods sold under a
warranty for repair/ replacement.

4.9 A distributor would normally be liable to pay for repairs or

replacement for goods in an extended period. Normally,
the risk of goods breaking some months after the sale
would be borne by the buyer of the goods. The contract
therefore transfers this inherent risk from the buyer of the
goods to the retailer. This is therefore an insurance
contract.

4.10 This is a rather specialist examples. It is neither insurance

risk nor financial risk transfer. There is no transfer of
insurance risk to the writer of the policy since the writer of
the policy is able to recover any amounts they pay out by
adjusting the following year’s premium. This type of
“financial reinsurance” in substance is just an overdraft
facility. Any amounts claimed by the policyholder under
such a policy would be shown as liabilities in the
policyholder’s balance sheet.

Provisions

Provisions are liabilities of uncertain timing or amount. Applying

the principles of the Framework document, this covers potential
liabilities under an insurance contract.

96
If a policyholder has transferred insurance risk to another person
(or company), then the issuer of this policy could be expected to
be required to apply IAS 37.

IAS 37 specifically does not apply to insurance contracts, since

IFRS 4 gives more specific rules for insurance contracts than the
generic rules of IAS 37. It partially forms the base of the current
IFRS 4 and is likely to form the of the finalised standard in a few
years.

Long-tail insurance

The “tail” of an insurance claim is the time delay between a loss

being incurred and that loss being reported to the insurer. For
example, whiplash injuries in a road traffic collision may only
become apparent to the victim several years after being involved
in a crash. Pollution and industrial disease claims can also take
years to become apparent, even if the event causing the loss
occurs today, so is covered by the insurance contract in force
today.

Where an insurance policy is written, with the expectation that if

a claim is made, it will be made in a long time, it may be
appropriate to discount the provision in order to show a true and
fair view of the insurer’s balance sheet.

97
This is consistent with the principles of IAS 37.

The effect of discounting and the choice of discount rate can

have a drastic effect on the results and reported liabilities of an
insurer.

IFRS 4 and discounting

The IASB has not prescribed any rules on which discount rates
to use, since this is considered largely subjective and it was
impossible for them to reach a consensus in the time available in
the time available for issuing the current version of IFRS 4.

The transitional rules with discounting given in IFRS 4 are:

(i) If companies currently use discounting to measure

technical provisions, they may either:

• Continue to use their existing policies, or

• Change to a policy of presenting insurance liabilities on
an undiscounted basis.

(ii) New insurance companies, or insurance companies

that currently do not present financial statements to
shareholders on a discounted basis, must present
insurance liabilities on an undiscounted basis. If
such companies write a large volume of long-tail
business, this may significantly overstate the true
value of their liabilities and thus understate their
solvency.

This is largely because of the subjectivity associated with the

choice of discount rate to use when calculating the present
values.

98
Case study 4.11

Imagine that an insurance company invests wholly in

irredeemable government bonds, which pay a fixed interest rate
of 5% per annum. If the company has just enough assets
(invested in government bonds, as above) to pay off its
estimated insurance liabilities as they fall due, changes in the
general rate of interest will change the value of the assets that it
holds, as above.

Changes in general interest rates will change the valuation of

the company’s investments.

If the company held assets of $10,000,000 and liabilities of

$7,500,000 (at NPV, discounted at 5%) on 1 January 2001, the
insurance company is solvent.

Imagine now that interest rates rise to 8%. The investments’

valuation will now fall to (62.5/100 x $10million) $6,500,000. If
the insurance liabilities are shown as the same value, the
balance sheet will become insolvent.

This would not give a true and fair view, since the company
could invest $6,500,000 now and be confident that the funds
would grow to the amount needed to pay off the liabilities, since
investment returns have increased.

Matching discounting of provisions to the assets held

The discount rates used to discount long-term insurance

liabilities should be based on conservative estimates of the rates
that the company expects to obtain from its investments.

Liability adequacy test

Although IFRS 4 does not require insurers to discount provisions

for the figures routinely given to investors, it is still necessary for
insurance companies to use some of this methodology.

Issuers of insurance contracts are required to assess if the

presented liabilities are adequate to cover expected claims.
This is true even if claims are shown on an undiscounted basis.

99
Case study 4.12

Glum Co is an insurance company that specialises in long-tail

general insurance.

It has written policies for environmental damage with income in

the past of $15,000,000. These policies cost $1,000,000 to
acquire and these acquisition costs are being deferred over a
period of 5 years. At the end of the current year, remaining
deferred acquisition costs are $450,000.

The liabilities for these types of policy were estimated in the

most recent accounts to be $18,000,000, on an undiscounted
basis.

Recent experience has shown that this type of insurance policy

is likely to experience much greater losses than originally
expected.

It is now expected that the total amount of claims expected will

be around $25,000,000 and that these claims will be paid in 5
years. Glum Co has investments that yield an average return of
6% per year and the company considers that this would be an
appropriate rate to discount this liability, in accordance with the
rules of IAS 37.

Required:

Assess whether the company’s recorded liability for expected

claims on these insurance policies is adequate. If not, outline
the impact on the financial statements for these types of
insurance policy.

Note: This requirement is the same as saying “Conduct a liability

adequacy test in accordance with paragraphs 11 – 13 of IFRS 4”

Solution to case study 4.12

$’000s
Current provision 18,000
Less: Deferred acquisition costs (450)
Net credit in balance sheet 17,550

Required provision:
25,000 x 1/ (1.06)5 18,681

Dr Income statement (18,681 – 17,550) 1,131

Cr Insurance liabilities 1,131

100
Case study 4.12 continued

Imagine that the following year, Glum finds that the conditions
are worse than expected. The amount that is now expected to
be paid out on these policies is $32,000,000. These amounts
are still expected to be paid on the originally estimated date, but
expected investment returns have now increased from 6% to
8%.

Required:

Describe the impact on the balance sheet and income statement

of Glum Co in this following year.

Solution to case study 4.12 continued

Following year provision required:
32,000 x 1/ (1.08)4 23,521

Dr Income statement (23,521 – 18,681) 4,840

Cr Insurance liabilities 4,840

Equalisation provisions

It is common practice for issuers of insurance contracts to build

up provisions (reserves) over a number of years to smooth
profits when a large series of claims comes into the insurer,
such as to cover the cost of claims arising from expected future
hurricanes.

IFRS 4 forbids the use of any such provisions, since they do not
meet the definition of a liability, as there is no obligating event to
incur a catastrophe in the future.

In effect, results must be shown with no smoothing. This can be

expected to produce much more variable results for insurers that
apply IFRS 4 than those currently using equalisation provisions.
This may increase the perceived risk by investors of investing in
companies issuing insurance contracts.

Reinsurance

The income statement of a life insurer should classify the gross

written premiums and net written premiums, in order to give an
indication of how much insurance risk is being reinsured
outwards.

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IAS 36 applies to amounts recoverable from reinsurers. A
company presenting results under IFRS 4 is required to assess
the willingness and ability of reinsurers to pay, both for
determination of:

• Current amounts due from reinsurers (on claims notified)

• On future claims expected from reinsurers for claims
incurred but not reported.

Deferred Acquisition Costs

IFRS 4 permits the policy of deferral of acquisition costs and of

premiums earned and unearned.

Little precise guidance is given on how to apply this, as these

are areas left for phase 2 of the insurance accounting project.

Issues specific to life insurance

Life insurance policies vary widely in what they cover. The issues that particularly
need to be addressed when accounting for life insurance policies are:

• “Unbundling” life policies between deposit and insurance

element
• Accounting for discretionary participation features (eg
“with profits” life insurance policies).

Example of unit-linked endowment

Imagine a whole life insurance policy, in the form of an

endowment policy. These types of policies are common with
endowments that are used to repay mortgage loans to purchase
homes.

Imagine that the investor invests a fixed amount of $50 per

month. This is then accumulated in a fund, with the life office
withdrawing an annual management fee of 2% of the fund’s
value.

The policy is designed to mature in 20 years to an amount

sufficient to repay the policyholder’s mortgage loan, plus
provide some funds extra. The value of the fund is not
guaranteed, and if the value of the fund in 20 years is not
sufficient to repay the policyholder’s mortgage loan, the life
office offers no compensation for this.

102
In the event of the early death of the policyholder before the
policy matures, the life office agrees to pay over the greater of (i)
the accrued value of the endowment fund and (ii) the
outstanding mortgage loan.

This type of arrangement is both an investment vehicle for the

policyholder and also a form of insurance.

There is no transfer of financial risk to the insurance company

from the policyholder, since the insurance company offers no
guarantee of the fund’s value.

The policy, however, contains both a deposit component and

also an insurance component. Both need to be shown
separately by the issuer of the policy.

Impact of the balance sheet approach to life insurance accounting

Each time that a new member joins a policy with a life insurance
element, the recognition of the life insurance element drastically
reduces profit compared to the profit reported under a more
cash accounting based system.

Discretionary participation features

It is common for life insurance policies that contain many of the

characteristics of investment vehicles to offer discretionary
bonuses to policyholders if investment returns are strong.

If a life insurance office has a return greater than a guaranteed return, this may be
retained by the life office as a profit, or awarded to investors as a bonus. This bonus
is normally awarded in the form of “bonus units”, which increases the valuation of
each endowment holder’s deposit.

The managers of a fund such as this one have a number of

choices as to what to do with the results of a better-than-
expected performance by investors:

• Award it to investors as a bonus

• Withdraw it as profits by the life office
• Some mixture of the two.

In practical terms, it is generally a competitive decision between

life insurance companies how much of this surplus is given in
bonuses to policyholders and how much is retained. It is also
common for companies to hold it in a “suspense” account on the
balance sheet. If the amount is given to policyholders as bonus

103
units, this reduces the life insurer’s solvency. Equally,
withdrawing it as profit can have adverse effects in the
marketplace relative to other insurers.

If such a surplus fund exists, but there is no obligation to pay it

as bonuses to investors, it fails to meet the definition of an
obligation in the IASB Framework document.

If it is not declared as shareholders’ profit, it similarly fails to

meet the intended definition of equity (eg shareholders’
accumulated profits).

Many companies used to present the results of this in a

“mezzanine” presentation between liabilities and equity.

CASE ILLUSTRATION

Extract from the accounting policies section in the financial

statements of Aviva plc (the parent company of Commercial
Union life insurer):

“The fund for future appropriations is used in conjunction with

long-term business where the nature of the policy benefits is
such that the division between shareholder reserves and
policyholder liabilities is uncertain. Amounts whose allocation
either to policyholders or shareholders has not been determined
by the end of the financial year are held in the fund for future
appropriations.”

Since this accounting policy note was published, Aviva has

reclassified this fund as a liability, in order to better comply with
IFRS 4.

IFRS 4 specifically prohibits this treatment, since it requires that

all items in the balance sheet are classified as one of the
elements of financial statements, being:

• Assets
• Liabilities
• Equity
• Gains
• Losses.

A mezzanine, or “hanging”, presentation of a number that can be

highly material in the balance sheet is not allowed. Issuers of
insurance contracts such as this one need to decide an
accounting policy on whether the entire discretionary amounts
are shown as liabilities, equity or some split between the two.

104
Financial Instruments
IAS 32: Presentation
IAS 39: Recognition and Measurement

IFRS 7: Disclosures

Purpose of these notes

IAS 32 and IAS 39 are rather complicated accounting standards

which mostly affect much larger entities. The purpose of these
notes is to help the reader identify which types of transactions a
smaller entity is likely to engage in that may unexpectedly
require compliance with these standards. The notes are
intended to be an introduction to the pervasive themes of the
standards, in order to enable the reader to then be able to
navigate through IAS 32, IAS 39 and IFRS 7 with greater
efficiency and confidence. These notes do not cover most of the
technical content of these standards, but are instead intended to
be a bridge enabling a reader with little prior experience of
accounting for financial instruments to then be able to read and
apply the standards with greater confidence and efficiency.

Scope

These three standards together give the rules for accounting for
financial instruments and for hedging transactions. The rules for
hedging are included within IAS 39 since derivatives are a
common means of hedging risk.

The standards do not cover certain transactions governed by

other standards, including:
• those interests in subsidiaries, associates and joint
ventures that are consolidated, or are accounted for
using the equity method or proportionate consolidation in
accordance with IAS 27 Consolidated and Separate
Financial Statements, IAS 28 Investment in Associates or
IAS 31 Interests in Joint Ventures;
• rights and obligations under leases (IAS 17 Leases).
However:
lease receivables recognised by a lessor are
subject to the derecognition and impairment
provisions of IAS 39;
finance lease payables recognised by a lessee
are subject to the derecognition provisions of IAS
39; and

105
 derivatives that are embedded in leases are
subject to the embedded derivatives provisions of
IAS 39.
• employers’ rights and obligations under employee benefit
plans (IAS 19 Employee Benefits);
• financial instruments issued by the entity that meet the
definition of an equity instrument in IAS 32 (including
options and warrants).
• rights and obligations under an insurance contracts as
defined by IFRS 4 Insurance Contracts, and under a
contract that is within IFRS 4 because it contains a
discretionary participation feature. However, IAS 39
applies to derivatives embedded in such a contract;
• contracts for contingent consideration in a business
combination (IFRS 3Business Combinations);
• contracts between an acquirer and a vendor in a
business combination to buy or sell an acquiree at a
future date;
• loan commitments that cannot be settled net in cash or
another financial instrument (except those that are
designated as financial liabilities at fair value through
profit or loss); and
• financial instruments, contracts and obligations under
share-based payment transactions (IFRS 2 Share Based
Payment), except certain contracts to buy or sell a non-
financial item as noted below.

These notes cover the various stages necessary to decide an

appropriate IFRS-compliant accounting treatment of financial
instruments, being:

• Initial recognition of financial instruments

• The debt/equity split

• Initial classification, for which the motive for buying the

financial instrument is critical

• Initial valuation

• Subsequent valuation

• Reporting changes in value

• Derecognition

• Disclosures about risk.

The need for the standard

106
Financial instruments are now mainstream commercial
transactions, with trillions of unsettled derivatives (see definition
below) unsettled at any point in time. Accounting rules for
accounting for financial instruments became more necessary as
the transactions themselves became much more common over
time.

Prior to the introduction of IAS 39, there were great

inconsistencies in classification of financial instruments,
especially where some financial instruments have some
characteristics of debt and other characteristics of equity such
as with convertible bonds. To enable comparability between
companies and consistent calculation of important ratios such as
the gearing ratio, IAS 32 requires a standard presentation of
such items.

There has been an enormous growth over the last decade in the
use of derivatives for managing risk or, in direct opposite
motivation, for speculation in high risk investments. Many such
contracts often don’t require any cash flow until the final
outcome of the “bet” is known. Prior to the introduction of IAS
39, many companies were failing to show large expected losses
in their year-end financial statements, since there had been no
cash flow by the balance sheet date as the bet was not yet
required to be settled. The spectacular failure of companies
such as Barings Bank created a demand for consistent, timely
reporting of expected gains or losses on financial investments as
well as thorough disclosures of what investment activities
companies were undertaking and the likely risks associated with
these investments.

Transactions typically caught by these standards

For the smaller reporting entity that doesn’t intentionally engage

in hedging strategies using financial investments or have an
active investment activity, IAS 39 is likely to apply to two types of
transactions:

• Long-term investments, including investments in

redeemable bonds.

• Guarantees given over the value of something, including

the value of an exchange rate, perhaps by guaranteeing
an exchange rate in a sale of goods to a foreign buyer.
Anything which appears to have the characteristic of a
bet is likely to be covered by IAS 39, as this may well be
a derivative.

Definitions (paraphrased for simplification)

107
 • A financial instrument is any contract that gives rise to
a financial asset of one entity and a financial liability or
equity instrument of another entity.

• A financial asset is cash, an equity investment in

another entity (eg an investment in shares) or a
contractual right to receive cash or some other benefit
from another entity.

• A financial liability is a contractual obligation that will

require the entity to deliver cash or some other value to
another entity.

• An equity instrument is any contract that evidences a

residual interest in the assets of an entity after deducting
all its liabilities. In other words, it’s an interest in the net
assets of another business, such as a share in that other
business.

• A derivative is a contract which varies in value in

response to a change to some underlying asset (eg
exchange rate, interest rate, commodity price); which
requires little initial investment and which is settled at a
future date. Derivatives have many of the characteristics
of a bet on the future value of something.

• An embedded derivative is a bet hidden within an

otherwise normal appearing contract.

• Fair value is the amount for which an asset could be

exchanged, or a liability settled, between knowledgeable
willing parties in an arm’s length transaction.

Note: Fair values are a pervasive theme in IAS 39.

The full definitions are given in IAS 32 paragraph 11 and IAS 39

paragraphs 8 – 13.

RECOGNITION

Initial recognition and disclosure

All financial instruments are recognised as soon as the entity

becomes contractually bound by them. This means that they
are often recognised in the financial statements before any cash
is paid over.

This is consistent with the Framework definitions of asset and

liability. For example, a financial liability is recognised where at
any point there is an obligation on the reporting entity to transfer
funds to a third party, even if this obligation is not due for
immediate settlement. A derivative which looks likely to lose
money is therefore a financial liability that must be recognised

108
even if it is due to be “cashed out” (ie settled) some time in the
future.

Upon recognition, even if there has been no cash flow, the entity
must make all of the disclosures of IFRS 7. These are left to the
end of these notes. In summary, the disclosures should enable
an investor to understand what financial instruments the entity is
exposed to, why they chose to take the exposure and what the
perceived risks of the investment in the financial instruments
are.

The disclosure requirements of IFRS 7 are given at the end of

this chapter.

THE DEBT/ EQUITY SPLIT

A significant thrust of IAS 32 is to ensure consistency in

recognition of financial liabilities and equity. Reporting entities
are typically keen to minimise the amount of debt reported on
the balance sheet, since the presence of debt is seen to
increase business risk and thus increase cost of capital. IAS 32
requires that where a financial instrument has the characteristics
(ie commercial substance) of debt, it must be reported as debt
regardless of its legal form. For example, a redeemable
preference share imposes a clear obligation on the issuer to
transfer out economic benefits in the future, so must be
classified as debt in the IFRS financial statements, despite
legally being a share. Other financial instruments may have
some of the characteristics of debt and some of equity. The
approach is to identify what asset has been received on the
issue of a financial instrument, identify how much of this
represents a liability with the residual amount being reported in
equity.

Compound instruments

A compound instrument is one that combines the characteristics

of both debt and equity. The principal example of these is a
convertible bond.

A convertible bond is a loan note which contains a right, but not

obligation, for the holder of the bond to require the issuer to
issue a pre-set number of shares upon redemption of the bond
instead of redeeming it for its stated redemption value. The
existence of the obligation means that there is an element of
debt within the instrument. However, a convertible bond will be
initially issued for a greater value than a non-convertible (often
called “straight”) debt as the option to convert will have some
intrinsic value. Note that an option can only ever have a positive
value, although that positive value may be very small and close
to zero.

109
From the perspective of the issuer, application of Framework
principles will produce the correct results.

Case study 39.11

On 1 January 20x1, Manjet Ltd issues convertible bonds with

a nominal value of $1,000,000. Each bond pays an annual
coupon in arrears of 4% of nominal value. The bonds are
redeemable by the holder on 31 December 20x5 at their
nominal value. Assume that no transaction costs were
incurred in the issue. The holder of the bond has the option
to convert each $100 block of debt into 40 ordinary shares in
Manjet on 31 December 20x5. The issuer has no option to
require that the bonds are converted.

Manjet has a BBB credit rating. Bonds issued by companies

with a BBB credit rating and a similar redemption date are
currently trading with a yield of 5%.

Required

If the bonds were not convertible, suggest a maximum price

that Manjet would be able to issue the bonds for on 1 January
20x1. Ignore transaction costs.

If the bonds were issued with the holder’s option to convert

and were issued for total consideration of $1,025,000 show
how this would be reported in the financial statements of
Manjet at the issue of the bond and at 31 December 20x1.

Solution to case study 39.11

If the bonds were not convertible, the initial issue price would be
such that an investor could expect to receive a yield of 5% over
the life of the bonds. This means that the issue price would be
the net present value of the expected cash flows, discounted at
5% pa.

Net present value of coupon annuity:

$40,000 pa for 5 years, discounted @ 5% 173,179

Net present value of redemption:

$1 million end of year 5, discounted @ 5% 783,526

Total initial liability @ 1 January 20x1 956,705

110
This means that for a straight debt with these terms (coupon
4%) to sell in a market that is currently demanding a return of
5%, it would need to be priced at a discount so that each $100
block would sell for a maximum price of approximately $95.67.

Assuming that the bond contained the option to convert at issue

and was issued at a premium of 2.5% on nominal value the
initial recognition in the financial statements on 1 January 20x1
would be:

Proceeds from issue 1,025,000

Less: Net present value of non-convertible debt

(with same coupon and redemption: see above) (956,705)

Equity as residual interest 68,295

As with the bonds in the case studies below, this bond would
then be shown at amortised cost, using an annual effective rate
of the initial internal rate of return (here 5%). So at the end of
year 1, the charges in the income statement and year-end value
in the balance sheet would be:

Interest expense (5% x $956,705) 47,835

Liability in balance sheet

($956,705 + $47,835 - $40,000) $964,540

This technique of determining year-end liability is elaborated

further below. Do not be too concerned if it seems unclear at
this stage.

If the convertible is eventually redeemed without conversion into

shares, the $68,295 will be transferred to retained earnings on
31 December 20x5. If the shares are issued, this figure will be
credited to share capital and share premium account to show
the consideration effectively received for the issue of these extra
shares.

111
 Framework focus
This accounting treatment in the books of the
issuer of a convertible bond is consistent with
the framework definitions of asset and liability.
The liability to the issuer (ie the unavoidable
obligation to transfer out assets) is the
obligation to pay coupon and redeem the bond.
If the option to convert is exercised, it does not
result in an outflow of resources, so does not
meet the definition of a liability. Equity is
defined as the residual interest of assets less
liabilities, meaning that the premium paid for the
option to convert is credited on issue of the
bond directly to equity.

Convertible bonds from holder’s perspective

The holder of a convertible bond will also have to unbundle the

bond into its pure debt and option elements. The initially
recognised values are likely to be as given above. In each
subsequent period, however, the option value must be revalued
to market value and the gain or loss reported either in equity or
the income statement, depending on whether the convertible is
held for trading, available-for-sale, etc as elaborated below.
Valuation of non-traded options is a highly complicated matter
and may involve techniques such as the Black-Scholes options
valuation model. It is likely that many companies use subjective
valuations based on what their investment manager or
department would be willing to pay for each convertible bond at
the end of each period and comparing that to the amortised cost
of “straight” debt.

Initial classification

In order to comply with IAS 32 and IAS 39, it is critical to ensure

that the financial instrument is appropriately classified. To do
this, it is probably logical to first identify and document the
motive for acquiring the financial instrument. Motives will
typically be one of:

• Hedging

• Short-term gain

• Longer-term gain.

Motive 1: Hedging

112
If an entity wishes to manage its risk to some uncertain future
event, it may well choose to take out a financial instrument as a
hedging item.

Case study 39.1

Fearful Co is an oil producer, based in Trinidad. It is obviously

exposed to the risks of the international market for oil, with the
price of oil being almost entirely outside Fearful’s control.

The company is concerned that if oil prices were to fall much

further below current spot prices, it would run into short-term
cash flow difficulties.

To protect against this risk, Fearful may take a number of

options, such as contracting to sell some of its oil “forward”,
meaning that it agrees a price with a buyer today for delivery at
some point in the future. This provides Fearful Co with
certainty of what its income will be. If spot oil prices then fall,
Fearful will win from the “bet” as it will sell at a price above spot
prices. Conversely, if oil prices were to rise, the contact to sell
forward will have an intrinsic negative value, since it imposes
an obligation on Fearful to sell at below market rates.

If Fearful cannot find a buyer that is willing to buy at a forward

price, it may hedge its risk by buying an oil price future. This is
a technique that effectively places a bet with another party on
the future price of oil. When the actual price is known, one
party wins and the other loses.

The important point at this stage is to recognise and thoroughly

document the motive for entering into the contract. In this
case, it was to hedge (ie protect against) a future drop in cash
flow arising from future sales. As will be shown later, this
transaction would be classified as a cash flow hedge under IAS
39.

Motive 2: Short-term gain

This motive is given the name “trading” in IAS 39. It means to

contact to buy or sell some financial instrument in the short-term,
very probably because the investor believes that the market for
that financial instrument (eg the value of a share) is getting the
price wrong. The investment in trading is to enter into a contract
such as to buy shares with an intention to reverse that position
quite soon after. This enables the investor to make a short-term
gain or dealer’s margin with a view to short-term profit taking.

Motive 3: Longer-term gain

113
This is where an investor intends holding a financial asset for a
long period of time, quite often where there is a maturity date to
the investment, such as an investment in dated US government
stock. Ordinary equity shares may be held for long-term
investment, but they cannot be intended to be held to a maturity
date since shares don’t have a maturity when the investor is
given their money back by the company.

An entity may also advance a loan to a third party for long-term

speculation or gain, such as a bank providing a household
mortgage to a lender.

CATEGORIES OF FINANCIAL INSTRUMENT

Upon identification of the motive for entering into the transaction,

the financial asset or liability must be categorised into one of the
four categories in paragraph 9 of IAS 39, being:

• Loans and receivables

• Held-to-maturity investments

• Available-for-sale financial assets

• Financial assets or financial liabilities at fair value

through profit or loss.

Category: Loans and receivables

This is quite a simple category. These are loans with known

payments that are not quoted on an active market, or if quoted
on an active market are held with a view to short-term resale.

For example, this category would include any loans advanced by

an entity such as a loan made to a customer on ordinary
commercial terms to enable the customer to buy a home.

Category: Held-to-maturity investments

There are non-derivative financial assets with known payments

and a fixed maturity date that the entity has both the positive
intention and ability to hold to maturity.

Category: Financial assets and financial liabilities at fair

value through profit or loss

114
Any asset or liability that is held for trading is automatically
included in this category. As the name implies, any financial
instrument in this category must be maintained at up to date fair
value with the moment in fair value being reported in full each
period in the income statement. An entity may designate any
financial instrument as being held at fair value through profit or
loss at its initial recognition.

Category: Available for sale financial assets

This is a residual catch-all category for financial assets that are

not any of the above categories. An entity may designate any
financial asset as available for sale on its initial recognition.

An available for sale financial asset is one which the entity does
not have any immediate intention of selling, but would be able to
sell without causing damage to the entity if it were advantageous
to do so.

VALUATION BASES

There are two valuation bases for all financial assets and
liabilities in IAS 32and IAS 39:

• Fair value (mostly governed by IAS 39)

• Amortised cost (mostly governed by IAS 32).

The reporting entity has some choice over which base to use,
although in some cases, the base is stated by IAS 32 or IAS 39.
For example, all derivatives are required to be recorded at fair
value.

Valuation base: Fair value (IAS 39 Appendix A, paragraphs

AG69 – AG82)

Where a financial instrument is valued each period to its fair

value, it is initially recognised at its fair value. This is logical,
since it is likely to have been purchased for its fair value in the
first place. If an item is to be held at fair value through profit or
loss (see below), any transaction costs associated with its
purchase must be written off immediately to the income
statement. Otherwise, transaction costs are added to the initial
carrying value (IAS 39, paragraph 43).

Determination of fair values for quoted instruments is a relatively

straightforward matter, normally being the bid price (ie the lower
of the bid-offer spread if one exists), without deducting any
expected transaction costs. If the entity has access to more

115
than one market, items should be valued at the highest available
bid price.

Valuation of non-traded financial instruments is a more

challenging task. In the absence of an active market for the
financial asset, the entity must use other bases for deciding a
value, which might include (Paragraph 74, Appendix A, IAS 39):

• Recent arm’s length transactions in similar (or the same)

financial instrument, or

• Reference to the value of similar securities in an active

market (although presumably making some allowance for
relative liquidity; evidence suggests that shares in
unquoted companies are worth around 30% less than
shares in quoted companies to reflect the greater
difficulty in finding buyers), or

• Discounted cash flow analysis of expected cash flows,

timing of cash flows and an appropriate risk adjusted
discount rate, or

• Options pricing models such as the Black-Scholes model

(this would be a very complicated means of deciding a
fair value in almost all cases so is probably not to be
preferred).

If discounted cash flows are used, these are inherently

judgemental and thus difficult to both question and to defend.
Care should be taken, however, not to make errors of principle
such as:

• Mixing inflation adjusted cash flows with non-inflation

adjusted discount rates, and/or

• Producing highly cautious discounted cash flows on

something close to a worst-case scenario and then
double counting risk by discounting these cash flows at a
high risk adjusted discount rate rather than a general
return expected on similar securities.

Valuation base: Amortised Cost

Amortisation is the process of transforming one number into

another number over time. The phrase is commonly used to
describe the process of transforming an intangible asset such as
a patent with a known life to zero value by periodic write-off.
The same process is often used in IAS 32 and IAS 39 to
transform one smaller number over time into a larger number.

Amortised cost is probably the more simple basis for

determining numbers for financial instruments under IAS 32 and

116
IAS 39 as it does not require annual restatement of asset or
liability values to fair values.

It does, however, require reasonable certainty about what the

cash flows will be.

IAS 32 requires that assets recognised initially at cost are then

subsequently valued to amortised cost, using the effective
interest method (paragraph 9 IAS 39).

Definition: The effective interest rate is the rate that exactly

discounts estimated future cash payments or receipts through
the expected life of the financial instrument or, where
appropriate, a shorter period to the net carrying amount of the
financial asset or liability.

In other words, the effective interest rate is the internal rate of

return of the financial instrument: the discount rate where its net
present value is zero. In practical terms, this can be estimated
by using the =IRR() function in Excel or similar spreadsheets or
calculators.

Case study 39.2

Globe Co issues deep discount bonds on 1 January 20x1. The

bond carries an annual coupon (payable in arrears) of 3% of
nominal value. Each $100 block of the bond was issued for
consideration of $84.40. The bond is due for redemption on 31
December 20x5. The total nominal value of bonds in this issue
were $10 million.

Globe Co paid $80,000 to a bank to administer the issue.

Globe Co designates the bond under the category of “loans

and receivables” per IAS 39. It has the positive intention and
ability to hold the bond to its maturity.

Required

Show the carrying value of the bond in Globe’s financial

statements for the year to 31 December 20x1.

Suggested solution

The total expected cash flows relating to this bond first need to
be identified.

1 January 20x1: Cash inflow from issue $8,440,000

Issue costs ($80,000)

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Total initial cash flow $8,360,000

31 December 20x1: Coupon annuity ($300,000)

31 December 20x2: Coupon annuity ($300,000)

31 December 20x3: Coupon annuity ($300,000)

31 December 20x4: Coupon annuity ($300,000)

31 December 20x5: Coupon annuity ($300,000)

31 December 20x5: Redemption ($10,000,000)

Total cash flow 31 December 20x5: ($10,300,000)

1 Jan 20x1 8,360,000

31 Dec 20x1 (300,000)
31 Dec 20x2 (300,000)
31 Dec 20x3 (300,000)
31 Dec 20x4 (300,000)
31 Dec 20x5 (10,300,000)

IRR 7.00%
This is calculated in Excel as =IRR(B1:B6)

The annual interest charge is then charged using the interest

rate implicit in the bond, ie its IRR. This is a similar principle to
accounting for finance leases (IAS 17) and accounting for
provisions (IAS 37).
1 Jan 20x1 Initial value 8,360,000
31 Dec 20x1 Interest @ 7% 585,200
31 Dec 20x1 Coupon (300,000)
31 Dec 20x1 Liability 8,645,200

31 Dec 20x2 Interest @ 7% 605,164

31 Dec 20x2 Coupon (300,000)
31 Dec 20x2 Liability 8,950,364

1 Jan 20x3 Interest @ 7% 626,525

1 Jan 20x3 Coupon (300,000)
1 Jan 20x3 Liability 9,276,889

31 Dec 20x4 Interest @ 7% 649,382

31 Dec 20x4 Coupon (300,000)
31 Dec 20x4 Liability 9,626,272

31 Dec 20x5 Interest @ 7% 673,839

31 Dec 20x5 Coupon (300,000)
31 Dec 20x5 Liability 10,000,111
31 Dec 20x5 Cash (10,000,000)

118
 Rounding
error 111

Financial statements extracts

Balance sheet

Financial liability: bonds $8,645,200

Income statement

Interest expense $585,200.

The principle of amortised cost requires up-front calculation of

internal rate of return but unless there is a change in the
expected cash flows leading to an impairment, or a
reclassification as available for sale, the figures are
comparatively stable. There is then no need to establish fair
values.

Case study 39.3 (continuation of 39.2)

Suppose that bonds with a nominal value of $100,000 were

purchased by Chiquitita Co on 1 January 20x1, incurring
transaction costs of $3,000. At 31 December 20x1, prevailing
market interest rates for this type of bond have risen from 7%
as they were at the issue of the bond to 8%. The bonds had an
ex-interest price of $77.26 per $100 block at this date.

Required

Explain how Chiquitita will show the bond in its financial

statements in each of the following situations:

• If the bond had been designated on its purchase as

held-to-maturity by Chiquitita if Chiquitita has the
positive intention and ability to hold the bond to its
maturity on 31 December 20x5

• If the bond was designated by Chiquitita on its original

purchase as being held at fair value through profit or
loss

• If the bond at its original purchase had been designated

by Chiquitita as an available for sale financial asset.

119
Solution

If the bond has been designated as held-to-maturity and

Chiquitita has the ability to designate it as such, the bond would
be measured at amortised cost, using the internal rate of return
of the bond from Chiquitita’s perspective. This would involve
estimating all of Chiquitita’s cash flows including its acquisition
costs and finding the bond’s IRR from those cash flows. This
would be the basis of the interest cost and balance sheet
carrying value.

The variation in market price would not be relevant as the asset

would not be shown at fair value unless it is necessarily
reclassified as an available for sale financial asset (eg if
Chiquitita lost the ability to hold to bond to maturity or stood
ready to sell it).

If the bond had been designated at its purchase as being held at

fair value through profit or loss, then the variation in market
value would need to be recorded. Assuming that there was no
difference between the fair value of the bond at its purchase and
the value Chiquitita paid for it, it would initially be recorded at a
fair value of $84,400. The $3,000 transaction costs would be
written off immediately as an expense as they do not increase
the fair value of the bond.

At the year end, the bonds would be revalued to their bid price of
$77,260, meaning that a loss would be reported in the income
statement of $7,140 ($84,400 - $77,260).

If the bond is designated as an available-for-sale financial asset,

the balance sheet must show the latest fair value. The loss may
be reported either in the income statement or in equity (see
below for further details of this).

SUMMARY: INITIAL RECOGNITION AND SUBSEQUENT

VALUATION

The table below summarises the appropriate accounting

treatments for various financial instruments bought for
investment purposes (but not for hedging purposes).

120
 HTM A-F-S FA FVPL L&R

Initial value Cost, including Cost, Cost, including Cost, including

acquisition excluding acquisition acquisition
costs acquisition costs costs
costs

Subsequent Amortised cost Fair value Fair value Amortised cost

value

POSSIBLE MEANS OF REPORTING GAINS AND LOSSES

Method 1: “All inclusive” reporting of gains and losses

Generally gains are reported in the income statement, with the

result that they reach equity as part of retained earnings. All
gains increase net assets of a business with the result that they
must somehow increase equity if the balance sheet is to
balance. This is how gains on financial assets or liabilities held
at fair value through profit or loss are reported each period in the
income statement and so also equity, thus:

Method 2: Reporting gains directly in equity

It is also possible to report gains directly in equity, which is how

revaluation gains on property plant and equipment are reported.
When the asset is then sold, the reported gain in the income
statement is calculated as the difference between the sales
proceeds and the revalued amount. This has the effect that a
realised gain between the purchase price and sale value is
never reported through profit. This is seen as a disadvantage of
this method.

121
Method 3: The hybrid approach of “recycling”

This method is refined for reporting gains on available-for-sale

financial assets. These are reported at fair value with the gain
reported directly in equity until the financial asset is eventually
derecognised. Upon derecognition, the cumulative gain in
equity is then reported in the income statement (Dr Equity, Cr
Income statement). This gain in income statement has the
effect of being then reported once more in equity as shown
below:

This has the perceived disadvantage of reporting the same gain

twice; once initially in equity and then later recycled through the
income statement and so to equity again.

There is conceptually no perfect means of reporting gains! IAS

39 specifies different reporting requirements depending on the
classification of each financial instrument, as given below.

HTM A-F-S FA FVPL L&R

Gain or Amortisation Change in fair Change in fair Amortisation

losses expense or value in value in or impairments
reported in impairments in income income in income
income statement or statement. statement.
statement directly to
equity using
recycling
approach (see
below).

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Case studies 39.3 – 39.6

Howard Co purchased the following investments in the year

ended 31 December 20x2:

39.3 On 1 January 20x2, it bought 400 bonds in Russell Co at

a price of $102.40. The bonds pay an annual coupon at
the end of each year of 7% and mature on 31 December
20x4. In the previous year, Howard Co had reclassified
some bonds from held-to-maturity to available for sale.
The bid market price of the bonds on 31 December 20x2
was $104.30.

39.4 On 1 December 20x2 it had entered into a forward

contract with a bank to sell USD 500,000 at a forward
exchange rate on 31 January 20x3 of TTD/USD = 6.45.
At 31 December 20x2, the spot rate was TTD/USD =
6.36.

39.5 On 29 December 20x2, it short sold 5,000 in Dara Co, a

listed company at a price of $4.60 each. (This means that
it sold shares that it did not own by borrowing them from
somebody else with a promise to replace them). On 31
December 20x2 it could have bought the shares in Dara
Co for $4.45.

39.6 On 18 December 20x2, it bought 1,000 shares in Frankie

Co for $2.34 each. The year end spread of prices was
$2.45 - $2.55. It pays 1% of all fees in transaction costs
to buy or sell investments.

Required

Calculate the figures to be shown in the income statement and

balance sheet of Howard co for the year ended 31 December
20x2 for the above transactions.

Impairment of financial assets held at amortised cost (IAS

39 paragraphs 63 – 65)

If there is objective evidence that a financial asset is impaired,

the carrying amount of the asset is reduced and an impairment
loss is recognised. All financial assets whether held at fair value
or at amortised cost must be recognised at an impaired value if
there is external evidence of their value being reduced.
Paragraph 61 of IAS 39 states that a significant or prolonged
decline in the value of an equity instrument should be
considered to be external evidence requiring impairment.
Unfortunately, the standard does not define what is meant by

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either “significant” or “prolonged”, which creates practical
difficulty. Given that the standard is not prescriptive in this
regard, it is a matter of accounting policy selection for the
reporting entity what “significant” and “prolonged” in this context
means. A policy should be established and applied consistently
to all financial assets. It may enhance the credibility of the
financial statements to state what the entity’s policy is for
identifying such losses. Where a market value is available by
reference to a deep market in the financial asset (for example
major shares traded on one of the World’s larger exchanges),
then it would be difficult to justify not recording a drop in market
value rapidly. However, where an entity holds a financial asset
that is thinly traded and where that entity does not appear to
have the intention or the need to sell the seemingly impaired
asset in the near future, there is greater doubt whether the
recoverable value of the asset truly has been impaired. It may
be possible for an entity to devise a formula for recognition of
impairment losses, taking into account the size of the apparent
impairment below carrying value and the number of days that
the most recent traded price for that asset has been below
carrying value. It may be wise for entities to designate certain
financial assets on initial recognition as thinly traded assets,
which would be slower to recognise impairment losses than
other financial assets. This is only a suggestion and it is up to
each entity to decide an appropriate methodology and apply it
transparently and consistently.

A financial asset carried at amortised cost is not carried at more

than the present value of estimated future cash flows. This net
present value is calculated using the revised cash flows of the
asset, but discounted at the original discount rate used to make
the estimates of amortised cost. An impairment loss on an
available-for-sale asset that reduces the carrying amount below
acquisition cost is recognised in profit or loss in full in the year
that the impairment becomes evident.

For investments in unquoted equity instruments that cannot be

reliably measured at fair value, impaired assets are measured at
the present value of the estimated future cash flow, discounted
using the current market rate of return for a similar financial
asset. Any difference between the previous carrying amount and
the new measurement of the impaired asset is recognised as an
impairment loss in profit or loss.

Case study 39.7: Impairment of financial asset held-to-

maturity

At the beginning of 20x5, a company makes a five-year loan of

$5,000 that has an effective and original interest rate of 7%,
received at the end of each year, and a principal amount of
$5,000 at maturity. At the beginning of 20x9, there is evidence
of impairment due to the financial difficulties of the borrower,
and it is estimated that remaining future cash flows will be

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$2,500 instead of $5,350 (principal plus interest). The impaired
asset is measured at the present value of the estimated future
cash flow, discounted using the original effective interest rate,
ie $2,500 discounted for one year at 7% ($2,336). Accordingly,
the impairment loss recognised at the beginning of 20x9 is
$2,664 ($5,000 - $2,336).

IAS 39 requires accrual of interest on impaired loans and

receivables at the original effective interest rate. In this case,
therefore, an accrual of interest at 7% would be made on the
carrying amount of $2,336, ie $164 in 20x9. For available-for-
sale financial assets, impaired assets continue to be measured
at fair value. Any unrealised holding losses that had previously
been recognised as a separate component of equity are
removed from equity and recognised as an impairment loss in
profit or loss.

Embedded derivatives

An embedded derivative is a hidden derivative, ie an option or a

bet hidden within another commercially dissimilar contract.
Embedded derivatives are still derivatives even if they’re hidden
and so, like all derivatives, they must be separately recognised
and shown each period end at their fair value. The embedded
derivative must be unbundled from its host contract. Normally
the change in fair value of a derivative is shown through profit or
loss, with the only exception being for a derivative held for
hedging (see below). It seems likely that any change in value of
an embedded derivative would be shown each period in profit or
loss therefore.

Guidance on what constitutes closely related and dissimilar risks

between a term that is suspected to be an emedded derivative
and its host contract is given in IAS 39 Appendix A paragraphs
AG 27 – AG 33. An important matter for oil companies is that if
oil is sold in US Dollars at an implied contracted rate, this is not
normally seen as an embedded derivative, since it is normal
world practice to price oil in US Dollars (IAS 39 Appendix A,
paragraph AG 33(d)(ii)).

Case study 39.8: Embedded derivative

A company invests in a convertible debt instrument at a cost of

$25,000. The fixed interest rate is 7% and it can be converted
into ordinary shares in 10 years’ time, at the company’s option,
or, the capital can be repaid at $25,000. The investment is
classed as available-for-sale.

The equity conversion option (the embedded derivative) is

separated from the host debt instrument because:

• there is an embedded derivative

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• it is not measured at fair value with changes in fair value
recognised in profit or loss

• equity and debt are not closely related characteristics.

The fair value of the equity conversion option is $3,250:

Dr Available-for-sale investment $21,750

Dr Derivative asset $3,250

Cr Cash $25,000

The derivative asset is accounted for at fair value with changes

in fair value recognised in profit or loss. The debt instrument is
accounted for as an available-for-sale asset at fair value with
changes in fair value recognised directly in reserves. The
difference between the initial carrying amount and the amount
of the available-for-sale financial asset of $3,250 is amortised
to profit or loss using the effective interest rate method. If it is
not possible to reliably measure the embedded derivative
element, then the instrument is treated as a financial asset or
financial liability that is held for trading.

Derecognition of financial instruments (IAS 39 paragraphs 15 –

42)
A financial liability is derecognised when the liability is extinguished.
A financial asset is derecognised when, and only when:

• the contractual rights to the cash flows from the asset expire;
or
• the entity transfers the financial asset to an unrelated third
party such that there is only an immaterial chance that the
entity may continue to benefit from any future inflows that the
financial asset may produce.
It is common in certain types of transactions for an entity to “close
out” a financial investment by becoming party to a financial
instrument that moves in the opposite way. For example, an entity
may buy a future that requires it to buy gold on 31 March for a set
price of $600 per ounce. A month later it may “close out” its
exposure here if the futures price have moved against it by entering
into a contract to sell the same amount of gold on the same date for
a set price of $560 per ounce. Whatever happens to the price of
gold on 31 March, the entity’s exposure is known. However, the
initial “buy” future cannot be derecognised since if the counterparty
to the second contract goes bankrupt, the entity still would have a
one-sided exposure.

To derecognise financial assets, paragraphs 15 – 42 of IAS 39 give

a number of conditions that require it to be virtually certain that the
entity’s exposure to the financial asset or financial liability is ended.

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HEDGING

Hedging is the process of protecting against adverse changes in

business circumstances affecting the future cash flows of a
business, or reducing the net asset value of assets recognised in
the balance sheet, or of increasing the fair value of liabilities. IAS 39
provides for two kinds of hedge accounting, recognising that entities
commonly hedge both the possibility of changes in the functional
currency value of future cash flows (ie a cash flow hedge) and the
possibility of changes in fair value of an asset or liability already
recognised in the entity’s balance sheet (ie a fair value hedge).

The first step in hedging is to identify which is the hedged item (eg a
receipt of USD that will need to be sold at an uncertain future
exchange rate to yield TDD) and which is the hedging instrument
(eg a forward currency contract for a Trinidad company to sell USD
in exchange for TDD at a set date in the future). All hedging
transactions will have a hedged item and a hedging instrument. If
the hedged item loses value, the hedging instrument will gain in
value and vice versa.

As some of the hedging rules allow for gains and losses not to be
reported in the income statement, strict conditions must be met
before hedge accounting is applied in order to prevent companies
using the hedging rules below to hide losses in reserves which are:

• There is formal designation and documentation of a hedge at

inception.

• The hedge is expected to be highly effective (ie the hedging

instrument is expected to almost fully offset changes in fair
value or cash flows of the hedged item that are attributable to
the hedged risk).

• Any forecast transaction being hedged is highly probable.

• Hedge effectiveness is reliably measurable (ie the fair value or

cash flows of the hedged item and the fair value of the hedging
instrument can be reliably measured).

• The hedge must be assessed on an ongoing basis and be

highly effective. This means that the band between which the
hedged item and hedging instrument can vary is only within a
range of 80% -125%.

When a fair value hedge exists, the fair value movements on the
hedging instrument and the corresponding fair value movements on
the hedged item are recognised in profit or loss. When a cash flow
hedge exists, the fair value movements, on the part of the hedging
instrument that is effective, are recognised in equity until such time
as the hedged item affects profit or loss. Any ineffective portion of

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the fair value movement on the hedging instrument is recognised in
profit or loss.

Case study 39.9: Fair value hedge

A company purchases a debt instrument that has a principal

amount of $1 million at a fixed interest rate of 6% per year. The
instrument is classed as an available-for-sale financial asset.
The fair value of the instrument is $1 million.

The company is exposed to a risk of the decline in the fair

value of the instrument if the market interest rate increases
because of the fixed interest rate.

The company enters into an interest rate swap. It exchanges

the fixed interest rate payments it receives on the bond for
floating interest rate payments, in order to offset the risk of a
decline in fair value. If the derivative hedging instrument is
effective, any decline in the fair value of the bond should be
offset by opposite increases in the fair value of the derivative
instrument. The company designates and documents the swap
as a hedging instrument. On entering into the swap, the swap
has a fair value of zero.

Assuming market interest rates have increased to 7%, the fair

value of the bond will have decreased to $960,000. The
instrument is classified as available-for-sale, therefore the
decrease in fair value would normally be recorded directly in
reserves. However, since the instrument is a hedged item in a
fair value hedge, this change in fair value of the instrument is
recognised in profit or loss, as follows:

Dr Income statement $40,000

Cr Available-for-sale financial asset $40,000

At the same time, the company determines that the fair value
of the swap has increased by $40,000. Since the swap is a
derivative, it is measured at fair value with changes in fair value
recognised in profit or loss. The changes in fair value of the
hedged item and the hedging instrument exactly offset each
other: the hedge is 100% effective and the net effect on profit
or loss is zero.

Case study 39.10: Cash flow hedge

A company trades in TDD and considers the TDD to be its

functional currency. It expects to purchase a piece of plant for 1
million Euro in one year from 1 May 20x6. In order to offset the
risk of adverse changes in the Euro rate, the company enters
into a forward contract to purchase 1 million Euro in 1 year for a
fixed amount (TDD 8.2 million). The forward contract is

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designated as a cash flow hedge. At inception, the forward
contract has a fair value of zero.

At the year-end of 31 October 20x6, the Euro has appreciated

and the value of 1 million Euro is TDD 8.4 million. The machine
will still cost 1 million Euro so the company concludes that the
hedge is 100% effective. The highly probable future cash flow
(to purchase the machine) has increased by TDD 200,000 but
the value of the contract to buy Euro at a cheaper than market
rate has gained in value by the same amount. Thus the entire
change in the fair value of the hedging instrument is recognised
directly in reserves in full. It is not recognised in the income
statement, since there is no gain or loss on the hedged item yet
in the income statement (as the hedged item is a forecast
future transaction that hasn’t yet been recognised in the
financial statements).

Dr Forward contract TDD 200,000

Cr Equity TDD 200,000

The forward contract is settled with no further change in the

exchange rate:

Dr Cash TDD 200,000

Cr Forward contract TDD 200,000

The company purchases the machine for 1 million Euro and

makes the following journal entry:

Dr Machine TDD 8,400,000

Cr Accounts Payable TDD 8,400,000

The deferred gain or loss of TDD 200,000 should either remain

in equity and be released from equity as the machine
depreciates, or be deducted from the initial carrying amount of
the machine. A hedge of net investment in a foreign operation
is accounted for similarly to a cash flow hedge.

Summary diagram for determining type of hedge

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Discontinuation of hedge accounting

If any of the following circumstances arise a company should

discontinue hedge accounting prospectively, meaning that
figures already reported are not changed, but that from this
moment onwards the hedged item and the hedging instrument
are treated as wholly independent transactions:

• the hedging instrument expires or is sold, terminated, or

exercised

• the hedge no longer meets the hedge accounting

conditions

• the company revokes the hedge designation

• a hedged forecasted transaction is no longer expected to

occur (in the case of a cash flow hedge).

For discontinued fair value hedges, any previous hedge

accounting adjustments made to the carrying amount of hedged
items are amortised over the remaining maturity of those assets
and liabilities. For discontinued cash flow hedges, hedging gains
and losses that have been deferred in equity generally remain in
equity until the hedged item affects profit or loss, except in
certain circumstances with forecast transactions.’

DISCLOSURES ABOUT ACTIVITIES AND RISK: IFRS 7

IFRS 7 is a comparatively simple standard compared to IAS 32

and IAS 39. Its function is to enable readers of the financial
statements to have a clear understanding of the activities,
valuation bases and risks taken by the reporting entity.

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The standard requires extensive, but largely self-explanatory,
disclosures about the value of each financial instrument by
category (eg available-for-sale, held-to-maturity); any
reclassifications and reasons for reclassifications. It also
requires disclosure of any financial instruments pledged as
collateral and the terms of any such pledges made.

Any hedges are required to be disclosed with description of the

items hedged, the hedging instruments, any changes in values
and offsets made in accordance with IAS 39.

The standard requires a number of qualitative and quantitative

disclosures about risks, separated into different types of risk.
Appendix A of IFRS 7 identifies the following types of risk
(wording simplified) which require significant disclosures:

Credit risk The risk of the other party failing to pay their
obligations on a financial instrument.

Liquidity risk The risk that an entity will encounter difficulty in

meeting obligations associated with financial
liabilities. Often called risk of gearing or
leverage.

Market risk The risk that the fair value or future cash flows
of a financial instrument will fluctuate because
of changes in market prices. Market risk can
be decomposed into currency risk, interest rate
risk and other price risk.

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IAS 12: INITIAL CASE STUDY

John, Paul, George, Ringo and Robbie are all sole traders in different
businesses. They each have received $100,000 in cash in the current year in
sales revenue. They all live in the same country, where there is a uniform
corporate tax rate of 30% on all profits. The tax system where they live is to
charge tax based on cash profits, with the exception of non-current assets
which are depreciated on various standard bases, depending upon the type of
asset.

For simplicity, none of these traders has any

assets.

You are given the following information about the

traders:

John

John is a public relations consultant. He spends approximately 40% of his

revenue on extremely expensive client entertaining and corporate gifts. None of
this entertaining or gift buying is allowed by the tax authority as a “legitimate”
business expense. His total expenses in the year were $69,350, $39,500 of
which was not allowed as a deduction against tax.

Paul

Paul is a fast food retailer, using the name of a major chain under a franchise
agreement. At the start of this year, he paid the franchise owner $180,000 for
the right to use the franchise name over a period of 6 years. The tax authority
allowed all of this payment as a deduction from tax in the current year. His total
expenses (in addition to the franchise fee) in the year were $46,000, $250 of
which was not allowed as a deduction against tax.

George

George sells foreign holidays. He is the only one of the traders not to have
started in business this year. He made tax losses in the previous four years to
a total of $450,000. Under the tax laws of the country, he is entitled to carry
forward these losses as a deduction against future profits from the same trade
for an unlimited time. He is not allowed to carry them back against profits of
previous years. His total expenses in the year were $83,000, $500 of which
was not allowed as a deduction against tax.

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Ringo

Ringo operates a car rental business. Normally, people pay in cash at the
same time as renting a car, but for big events using the most expensive cars
(mainly weddings) Ringo requires full payment in advance. This can be up to
six months in advance. At the year end of 31 December 2002, Ringo had
received cash of $24,500 for services that he had not yet provided, but was
required to provide in the following year. His total expenses in the year were
$64,700, $200 of which was not allowed as a deduction against tax.

Robbie

Robbie has been trading for one year only, but has already managed to find
himself the subject of a lawsuit, which his lawyer advises him that he will
probably have to settle early in the new year. The lawsuit relates to an incident
two months before the year end. The lawyer advises that Robbie will probably
have to pay $9,000 to settle the case and that the lawyer’s own fees will be
about $900. His total expenses paid in the year were $65,500, $1,000 of which
was not allowed as a deduction against tax.

Required:

• Decide an appropriate set of accounting

policies for the traders in the light of the
above information.

• Prepare outline income statements for the

traders for the year, including a
calculation of the tax that will be
demanded by the tax authority in that
year. Unless you are told otherwise, none
of the traders had any prepayments,
accruals or inventory.

• Assess whether the potential investors in

each of these businesses is being given
reliable information about sustainable
profits before tax and sustainable
information about profits after tax. Which
transactions are creating a problem and
what remedy might we suggest?

Suppose the following year they all continue to trade at exactly the same levels of
trade, with the only exception being that Ringo has not received any prepayments for
car rental. There were no changes to tax rates or tax law.

Required:

133
• Draft budgeted income statements for the
five traders, including your estimate of tax
payable.
• Compare the tax rate that each trader is
paying in the two years. Discuss whether
this gives a true and fair view.

134
Suggested solution to case study

John

John is paying a high rate of tax relative to his profits. This

is sustainable, though, as a high proportion of his expenses
are not allowable for tax and this is a core feature of his
business.

There are therefore no financial reporting issues to

consider in preparing John’s financial statements, as the
tax charge and tax rate he is paying already give a true and
fair view of his current and likely future profit.

John’s effective rate of tax (tax as a % of profit before tax)

has been:

• Year 1: 68.7%
• Year 2: 68.7%
• General rate of tax: 30%

This is a permanent feature of his business, as John

spends a lot of money on unnecessary things. He is
effectively being “punished” by the tax authority and there
is no evidence that this will change in the future. Any
investor investing money in John’s business can expect to
see approximately this rate of his profits being paid over to
the tax authority in the future on an ongoing basis.

Although his effective tax rate is therefore very much

higher than the general rate of tax, it is a sustainable figure
that gives a true and fair view.

Paul

The payment for the franchise fee meets the definition of

an asset in the IASB Framework document, since it is
something that Paul owns (or controls) that has an
identifiable cost and will give benefits into the future.

The appropriate accounting treatment therefore is to write

this cost off over its expected useful life, which here is
$180,000/6 = $30,000 per year.

The cost is initially recognised as an intangible asset under

IAS 38 but is written off over its useful life.

The tax treatment is different, with an immediate write off in

the current year. This means that the tax rate that Paul is
reporting (ie a zero tax charge) is completely
unsustainable. In the next year, he will be charging
$30,000 amortisation for the lease, but will receive no tax

135
relief on this expense. This will make his tax charge next
year very high. At the moment, there is no warning to
shareholders about this inevitable increase in tax in the
future so we are failing to give them a true and fair view of
sustainable profits.

Using the tax actually payable to the tax authority on an

unadjusted basis, this gives Paul tax rates (as a % of profit
before tax – as the shareholder sees) in year 1 and year 2
of:

• Year 1: 0%
• Year 2: 67.8%
• General rate of tax: 30%

There is clearly something very misleading here, as neither

Paul’s business, the tax rate, nor tax law have changed
and yet the tax rate is exceptionally variable!

George

As George has tax losses, he has not paid tax in either

year. The investor may think that this will continue forever
and assume that George’s business is exempt from tax. In
fact, one day the tax losses will run out and George will be
paying more than 30% of his profits to the tax authority. At
the moment, an investor has no way of knowing this.

Ringo

Although nothing has changed in Ringo’s business other

than the fact that he did not have any revenue to defer at
the end of year 2, his effective tax rate (tax charge as a %
of profit before tax) has shown this pattern:

• Year 1: 98.6%
• Year 2: 17.8%
• General rate of tax: 30%

Again, this is almost certainly misleading to an investor.

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Robbie

Robbie had recognised an expense as due in year 1, but

he paid the cash over in year 2. This had the effect of
distorting his effective tax charge a great deal.

• Year 1: 43.3%
• Year 2: 22.3%
• General rate of tax: 30%

Again, nothing in the tax law and nothing in Robbie’s

business had changed. This means that his year 1
effective tax rate of 43.3% gave a misleading impression of
what a recurring tax rate would be for him.

Compare this to John, whose tax rate was very high, but
permanently so. Robbie’s tax rate was only temporarily
very high.

The terms “permanent” and “temporary” will come up often

in our study of deferred tax!

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IAS 17: Leases

This chapter deals initially with the accounting for a transaction

by a lessee, as this is the main focus of lease accounting for
most businesses. An outline of accounting by lessors is given at
the end of the chapter.

The need for the standard

Companies will often use assets held under lease agreements.

The contracts that give the right to use the asset will often
generate a liability that is difficult or commercially impossible to
avoid. Leasing is seen commercially as an alternative means of
acquiring assets compared to borrowing funds to buy the asset
outright.

Although legally the asset may remain the property of the lessor,
the lessee often effectively has control of the leased asset for
most or even all of its useful life. The lessee also has an
obligation to pay future lease payments. Applying the principle
of substance over form from the Framework document, if a
company controls a large value of assets these assets should be
shown on the lessee’s balance sheet, even if they are not owned
by the lessee.

Framework focus
The Framework definition of an asset is a
resource controlled by an entity, rather
than owned. If an entity controls an asset,
that asset should be recognised at some
appropriate value on the lessee’s balance
sheet, even if there is no option for the
lessee to buy the asset from the lessor.
The Framework also defines a liability as an obligation to
transfer economic benefits, whether this is a legal or
constructive obligation. Often lease agreements are for long
periods of time, with no effective ability to avoid the contract
and thus avoid the future payments. This means that leases
often produce obligations that meet the definition of liabilities in
the framework document.

Case study 17.1

An airline signs ten agreements to lease ten new Boeing 787
aircraft. Each lease is not cancellable by the airline (or can
only be cancelled under terms that are so onerous that it is
unlikely that they would be cancelled) until the lease expires in
ten years.

Each lease allows the airline to use each aircraft for ten years,
but then also allows it to extend the period of the lease for a
further five years at an annual rental of $1 after the initial lease

138
term expires. The aircraft always remains the legal property of
Boeing and Boeing may seize the asset if rental payments are
not made on time. There is no clause in the agreement that
allows the lessee to purchase any of the aircraft at any time.
The design life of a new Boeing 787 is 25 years.

Required
Discuss the possible problems accounting for this transaction,
paying attention to:

• The Framework definition of an asset

• The Framework definition of a liability

• The concept of reporting commercial substance over

legal form

• How the company can give the most useful information

to investors about the sustainability of its profit and
cash flows.

Solution to case study 17.1

The legal form of the transaction is that the aircraft is never

owned by the airline, although it is under the airline’s use for
the majority of the expected life of 25 years. It seems highly
likely that the airline would lease the aircraft for 15 years rather
than 10 years, as the final 5 years involve very little cash
expenditure to retain use and control of the asset.

Through the expected life of the lease, the airline have control
of the aircraft and the aircraft is expected to generate benefits
for the airline (ie enable the airline to make sales). The aircraft
thus provides an expected inflow of benefits and is under the
airline’s control. This meets the definition of an asset under the
Framework and so the aircraft should be recognised in the
airline’s balance sheet.

The lease is non-cancellable, meaning that the airline has an

unavoidable commitment to make payments to Boeing for the
life of the contract. This is an obligating event causing an
expected outflow of benefits and is thus a liability in the books
of the airline that should be shown on the airline’s balance
sheet.

In commercial substance over legal form, the aircraft will be

shown as an asset of the airline, with an obligation to pay a
stated sum for the use of that asset. This is more useful
information to shareholders than simply recognising lease
expenses as paid and not including the aircraft on the

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company’s balance sheet, since to not recognise the aircraft
would give investors a misleading impression of the liabilities
(ie unavoidable obligations) of the airline and the assets
employed by the airline.

Case study 17.2

Consider the characteristics of the following lease agreements:

• A contract to rent a holiday cottage for a month

• A contract to rent a new car from a leasing company

for a period of five years.

• A contract to rent a photocopier for a period of ten

years.

Solution to case study 17.2

Renting a cottage for a month is a short time compared to the

expected life of the asset. It is unlikely that the renter would
consider the cottage to be an asset belonging to the renter, but
rather an asset which the renter has temporary use of. There
are also unlikely to be any material liabilities to pay for the use
of the cottage at the year end, unless the rent was unpaid, in
which case it could be fairly described as an ordinary current
payable.

The useful life of cars is variable depending on the car, but five
years appears to be a fairly long period of time. It is likely that
the renter would consider the car to be his/ her car. A car will
lose the great majority of its market value in the first five years
of its life. At the inception of the lease, the renter would be very
aware of the obligation to pay for the car for a period of five
years and the total liability to pay would quite possibly be close
to the market value of the car at the inception of the lease. In
substance, this may be more similar to a hire purchase
agreement for most companies than a simple rental. This is
slightly borderline but may be seen to be more akin to a
purchase agreement than to a simple rental agreement.

A photocopier is unlikely to have a life of greater than ten

years. This rental agreement will most probably be for
substantially the whole useful life of the asset. It is the same in
commercial substance as if the renter had borrowed money
from a third party and used this money to purchase a
photocopier. This will especially be true if the agreement is
non-cancellable, or cancellable only on adverse terms. This
would mean that the renter has an unavoidable obligation also

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to make payments for the next ten years.
TYPES OF LEASE

IAS 17 draws a distinction between two types of lease:

• Finance leases
• Operating leases.

A finance lease is a lease that transfers substantially all the

risks and rewards incident to ownership.

A lease is classified as an operating lease if it does not

transfer substantially all the risks and rewards incident to
ownership.

An alternative working definition of an operating lease is that

an operating lease is a lease that is not a finance lease!

The logic of IAS 17 is that assets should be recognised in the

balance sheet of the lessee if the lessee substantially has
control of the asset. This places the definition of a finance lease
on the definition of an asset in the Framework document.

Items that suggest a lease is a finance lease include (IAS 17,

paragraphs 10-11):

• Transfer of ownership of the asset to the lessee at the end of

the lease term (commonly referred to as a hire purchase
agreement)

• If the lessee has the option to purchase the asset at a price

which is expected to be substantially less than the fair value
of the asset at the date the option to purchase becomes
exercisable (commonly called a bargain purchase option)

• The lease term is for the major part of the economic life of
the asset, even if legal ownership is never transferred to the
lessee

• If at the inception (ie start) of the lease the present value of

the lease obligation (ie rental payments) amounts to
substantially all of the fair value of the asset at inception

• If the asset is so specialised that it is unlikely to be of any

use to any other business other than the lessee

• If the lessee guarantees that if the lessee cancels the lease,

the lessee will pay the lessor any losses the lessor suffers

• If the lessee has the ability to continue to use the asset after
the expiry of the minimum term of the lease for a rental that

141
 is below the market rentals that could then be charged for
that asset.

These are indicator only and it is very much a matter of

professional judgement whether a lease is a finance lease or an
operating lease. In practical terms, each company should draw
up its own tests and apply them consistently.

Why is the difference important?

Fairly small differences in the commercial nature of a lease can

make a great difference to the accounts as the accounting for
finance leases and operating leases is very different. In
summary:

Finance lease Operating lease

Asset Capitalised as if the Not on the balance

lessee owned the asset sheet of the lessee.
and depreciated as
normal.

Liability Obligation to pay future No liability to pay future

lease rentals recorded rentals shown in the
and discounted to net balance sheet.
present value.

Income Depreciation on the Only lease rentals as

statement leased asset an they fall due shown in
expense. the income statement.

Interest costs on the

unwinding of the
discounting of the
lease obligation shown
as an expense.

Disclosures Significant Relatively minor.

Most companies would prefer to have a lease agreement

interpreted as an operating lease rather than as a finance lease,
since finance leases immediately increase the reported gearing
of the company.

The following summary diagram should help in deciding whether

a lease is an operating lease or a finance lease:

142
 Start

Is ownership transferred Yes

by the end of the lease
term?

No

Does the lease contain a Yes

bargain purchase option?

No

Is the lease term for a Yes

major part of the asset’s
useful life?

No

Is the present value of the Yes

minimum lease payments
greater than or
substantially equal to (eg
90% of) the asset’s fair
value?

No

This is an operating lease This is a finance lease

Accounting treatment

IAS 17 requires that, when an asset changes hands under a

finance lease, lessor and lessee should account for the
transaction as though it were a credit sale. In the lessee'
s books
therefore:

DEBIT Asset account

CREDIT Lessor (liability) account

The amount to be recorded in this way is the lower of the fair

value and the present value of the minimum lease payments.

A variant approach which produces the same net result is to

debit the asset account with the fair value, and to debit an
interest suspense account with the total amount of interest or
finance charges payable under the agreement and to credit a

143
lessor account with the total amount (capital and interest)
payable under the agreement. We will see later how this affects
the year end accounting entries.

IAS 17 states that it is not appropriate to show liabilities for

leased assets as deductions from the leased assets. A
distinction should be made between current and non-current
lease liabilities, if the entity makes this distinction for other
assets.

The asset should be depreciated (on the bases set out in IASs
16 and 38) over the shorter of:

• The lease term

• The asset'
s useful life

If there is reasonable certainty of eventual ownership of the

asset, then it should be depreciated over its useful life.

COMPREHENSIVE CASE STUDY 17.3

Summary of Terms of Agreement for Lease of a Car

Lease term: Three years from 1 January 20x1

Rental: $600 per month

Deposit: None.

Timing of rental: Paid by the lessee into the lessor’s

bank account by the last day of each
month

Legal title: The lessor retains legal title at all

times until the lessor and lessee agree
that the lessee shall exercise their
purchase option (see below).

Purchase option: At the end of this lease, the lessee

shall have the option to purchase the
car for an amount of $5,000.

Guarantee of residual value: The lessee does not guarantee

any residual value of the car.

Insurance and maintenance: The lessee is responsible for

insuring the car and maintaining it to a
standard agreed with the lessor. The
lessee is responsible for any losses
arising for example due to theft, fire or
damage beyond normal wear and tear.

144
Repossession by lessor: If any lease payments are more than
one month, the lessor can obtain
immediate repossession and still
obtain all lease payments due.

Cash alternative purchase: The lessee may opt to buy the car
outright for its fair value at the
inception of the lease of $20,000. Any
payments made between inception
and exercise of this option shall not be
refundable by the lessor.

Assume that this type of car loses 25% of its market value each
year and that this is the lessee’s depreciation policy for cars
generally.

Also assume that the lessor incurs legal fees and other
incremental costs of $900 to sign the lease.

Suggested solution

Classification of lease

Is ownership transferred by the end of the lease term?

No.

Does the lease contain a bargain purchase option?

Yes it does, see working 1. The expected market value of the

car at the time when the option to purchase can be exercised
will be substantially greater than the cost of exercising the
option. It is therefore very likely that the option will be exercised.

Is the lease term for a major part of the asset’s useful life?

No, but it doesn’t matter, as we already have one “yes” answer,

so this is a finance lease.

Is the present value of the minimum lease payments greater

than or substantially equal to (eg 90%) of the asset’s fair value?

Yes (see working 1). But we wouldn’t have to calculate this in

order to describe this as a finance lease. We would, however,
have to do lots of calculations in order to determine how to
include this lease in the financial statements of the business.

145
Conclusion

On the basis of the information available, this is a finance lease,

because it has a bargain purchase option that means that legal
title is very likely to eventually be transferred. The non-current
asset will be included in the balance sheet of the lessee, as will
the liability to pay for it. There will be no future interest included
in this initial liability, since there is no obligation to incur this
liability for future interest. See working 2.

Dr Non-current assets $20,000

Cr Liabilities $20,000

Asset in lessee’s balance sheet

The asset would be included in the balance sheet of the

company and would therefore need to be depreciated as
required by IAS 16 Property Plant and Equipment.

The period of depreciation is the shorter of:

• The useful life of the asset, and

• The maximum lease term.

Here, the depreciation policy is given as 25% per annum on a

reducing balance basis.

Working 1

Expected market value of the car at the time of the option to

purchase being possible to exercise:

Market value at 1 January 20x1: $20,000

Expected market value at 31 December 20x3: $8,438

(0.75 x 0.75 x 0.75 x $20,000)

This is the cash that the lessee could reasonably expect to

receive from selling the car in year 3 if they were to purchase it
for a bargain purchase price of $5,000. They could therefore
expect to buy the asset from the lessor on 31 December 20x3
for $5,000 and sell it on for $8,438. As this is almost certainly
going to happen, the lease should be classified as a finance
lease.

Working 2

146
Net present value of the minimum lease payments at inception
of the lease.

To calculate the NPV of the minimum lease payments, it is first

necessary to identify from the lease what the expected pre-tax
cash flows of the lessor are, assuming that the bargain purchase
option will not be taken. This is to determine what the interest
rate implicit in the lease is.

IAS 17 states that the interest rate implicit in the lease is:

“…the discount rate that, at the inception of the lease, causes

the aggregate present value of (a) the minimum lease payments
and (b) the unguaranteed residual value to be equal to the sum
of (i) the fair value of the leased asset and (ii) any initial direct
costs of the lessor”.

This is a serious practical difficulty, since the figures may not be

known, for example how much the asset cost the lessor to buy.
It can also be onerous. For this reason, the short-cut methods
such as the sum of the digits method discussed later are often
used instead in practice.

Assuming that the lessor pays the car’s fair value of $20,000 at
the inception of the lease to buy the car, these are the cash
flows and timing of the lessor’s cash flows:

Month 0: Purchase of car and other marginal costs $20,900 cash outflow
Month 1 – 35 Lease payments $600 inflow
Month 36 Lease payment + highly probable purchase option $5,600 inflow

The IRR of these cash flows is 1.1543% per month (using Excel
=IRR() function or similar calculator).

Working 3

Calculation of the net present value of minimum lease

payments

DF @ DCF @
implicit implicit
Cash flow rate rate

Non-refundable
T0 deposit 0 1.1543% 0
T1 - T35 Rentals payable 600 1.1543% 17,195
Rental and
T36 purchase 5,600 1.1543% 3,705
Total 20,900

The month by month liability in the balance sheet of the lessee

can therefore be calculated as:

147
 Interest Total
Liab bf @ Cash Liab cf interest
1.1543%

Jan 20x1 20,900 241 -600 20,541

Feb 20x1 20,541 237 -600 20,178
Mar 20x1 20,178 233 -600 19,811
Apr 20x1 19,811 229 -600 19,440
May 20x1 19,440 224 -600 19,064
Jun 20x1 19,064 220 -600 18,684
Jul 20x1 18,684 216 -600 18,300
Aug 20x1 18,300 211 -600 17,911
Sep 20x1 17,911 207 -600 17,518
Oct 20x1 17,518 202 -600 17,120
Nov 20x1 17,120 198 -600 16,718
Dec 20x1 16,718 193 -600 16,311 2,611
Jan 20x2 16,311 188 -600 15,899
Feb 20x2 15,899 184 -600 15,483
Mar 20x2 15,483 179 -600 15,061
Apr 20x2 15,061 174 -600 14,635
May 20x2 14,635 169 -600 14,204
Jun 20x2 14,204 164 -600 13,768
Jul 20x2 13,768 159 -600 13,327
Aug 20x2 13,327 154 -600 12,881
Sep 20x2 12,881 149 -600 12,430
Oct 20x2 12,430 143 -600 11,973
Nov 20x2 11,973 138 -600 11,511
Dec 20x2 11,511 133 -600 11,044 1,933
Jan 20x3 11,044 127 -600 10,572
Feb 20x3 10,572 122 -600 10,094
Mar 20x3 10,094 117 -600 9,610
Apr 20x3 9,610 111 -600 9,121
May 20x3 9,121 105 -600 8,626
Jun 20x3 8,626 100 -600 8,126
Jul 20x3 8,126 94 -600 7,620
Aug 20x3 7,620 88 -600 7,108
Sep 20x3 7,108 82 -600 6,590
Oct 20x3 6,590 76 -600 6,066
Nov 20x3 6,066 70 -600 5,536
Dec 20x3 5,536 64 -5,600 0 1,156

EXTRACTS FROM THE FINANCIAL STATEMENTS

Balance sheet

Non-current assets

Non-current assets held under finance leases ($20,000 x 0.75) $15,000

Long-term liabilities

148
Finance lease liability
$11,044

Current liabilities

Finance lease liability ($16,311 - $11,044) $5,267

Income statement (extracts)

Depreciation on assets held under finance leases $2,500

Interest charges on finance lease liabilities $2,611

Notes to the financial statements

Included within creditors are finance leases with the following

minimum lease payments:

Payable within the next year ($600 x 12) $7,200

Payable between two and five years $7,200
Payable thereafter $0
Less: Future interest included in the above not yet due($3,089)
Total liability in the balance sheet $11,311

The net present value of lease payments due within the

following periods is:

(Note: this is the payments to be made, but excluding interest

that will become payable in that period).

Payable within the next year ($600 x 12) - $1,933 $5,267

Payable between two and five years $6,044
Payable thereafter $0
Total liability in the balance sheet $11,311

SHORTCUT ALTERNATIVE FOR APPORTIONMENT OF

RENTAL PAYMENTS

Lease rental payments are fixed payments for the duration of the
lease. They comprise two elements:

• An interest charge on the finance provided by the lessor

to enable the lessee in substance to purchase the asset
under a hire purchase agreement from the lessor. This
proportion of each payment is interest payable and
interest receivable in the income statements of the
lessee and lessor respectively.

• A repayment of part of the loan provided to the lessee by

the lessor. In the lessee'
s books this proportion of each

149
 rental payment must be debited to the lessor' s account to
reduce the outstanding liability. In the lessor'
s books, it
must be credited to the lessee' s account to reduce the
amount owing (the debit of course is to cash).

At the inception of the lease, the loan is very large. This means
that the large loan generates large interest charges. Towards
the end of the life of the lease, the loan is smaller, as it’s largely
been paid off, generating smaller interest charges. The fixed
repayments each period therefore comprise both an interest and
a capital element, as such:

Loan principal
element of each
payment
Interest
element of
each
payment

Time

In reality, the mathematics are a little bit more complicated than

a straight line like this (a straight line split between capital and
interest is prohibited by IAS 17 unless the difference between a
straight line apportionment and accurate apportionment using
either the actuarial or sum of digits method is immaterial). The
split between the two will look more like this:

Loan principal
element of each
payment

Interest
element of each
payment

150
 Time

The accounting problem is to decide what proportion of each

instalment paid by the lessee represents interest, and what
proportion represents a repayment of the capital advanced by
the lessor. There are two apportionment methods you may
encounter:

• The actuarial method, as in case study 17.3

• The sum-of-the-digits method, as an approximation to the

actuarial method.

The sum-of-the-digits method approximates to the actuarial

method, splitting the total interest (without reference to a rate of
interest) in such a way that the greater proportion falls in the
earlier years. The procedure is as follows.

(a) Calculate the total cost of finance over the period of the
lease as the total difference between the total amounts expected
to be paid less the cash price of the asset at the inception of the
lease.

(b) Assign a digit to each instalment. The digit 1 should be

assigned to the final instalment, 2 to the penultimate instalment
and so on.

(c) Add the digits. A quick method of adding the digits is to

n (n + 1)
use the formula where n is the number of instalments
2
and if the instalments (ie payments) are made in arrears rather
than in advance of each period, so that the last payment is made
on the final day of the minimum lease term. If the payments are
made in advance of each period, there will be one fewer interest
bearing period, as the first instalment will be paid to repay the
loan before any interest has accrued. This means that if
payments are made in advance, the sum of digits formula is
n(n − 1)
amended to .
2

(d) Calculate the interest charge included in each instalment.

Do this by multiplying the total interest accruing over the lease
term by the fraction:

Digit applicable to the instalment

Sum of the digits

151
Case study 17.4

On 1 January 20x1, Visitors Co signs a contract as lessee for

the use of some oil drilling machinery for a period of six years.
The contract requires an initial non-returnable deposit of
$20,000 and six annual payments of $45,000 to be paid at the
end of each year. At the end of the lease period, Visitors Co has
the right to extend the lease into a “secondary period” of up to
another six years at a further nominal annual rental of $1 to be
paid also at the end of each year.

The expected useful life of the drilling machinery is ten years.

The drilling machinery could be purchased for cash at 1 January
20x1 for $240,000. The lease is considered to transfer
substantially all the risks and rewards incident to ownership of
the drilling equipment to Visitors Co.

Required

Using the information above and the sum of the digits method of
allocation of finance lease costs, produce extracts from the
financial statements relating to leases at 31 December 20x1.

Solution

In this example, enough detail is given to use any of the

apportionment methods. In an examination question, you would
normally be directed to use one method specifically.

Total finance charges

Total amounts expected to be paid:

Initial non-returnable deposit $20,000

Lease payments ($45,000 x 6) $270,000

Total payable $290,000

Less: Cash price ($240,000)

Total cost of finance over 6 years $50,000

152
Allocation of total finance charge to each period

Interest bearing instalment Digit

First (31.12.x1) 6

Second (31.12.x2) 5

Third (31.12.x3) 4

Fourth (31.12.x4) 3

Fifth (31.12.x5) 2

Sixth (31.12.x6) 1

Total sum of digits 21

Accrued Loan
Date Payment interest principal

1.1.x1 Inception 240,000

1.1.x1 Deposit 20,000 (20,000)
31.12.x1 Interest ($50,000 x 6/21) 14,286
31.12.x1 Payment 45,000 (14,286) (30,714)
31.12.x1 Year-end 0 189,286
31.12.x2 Interest ($50,000 x 5/21) 11,905
31.12.x2 Payment 45,000 (11,905) (33,095)
31.12.x2 Year-end 0 156,191
31.12.x3 Interest ($50,000 x 4/21) 9,524
31.12.x3 Payment 45,000 (9,524) (35,476)
31.12.x3 Year-end 0 120,715
31.12.x4 Interest ($50,000 x 3/21) 7,143
31.12.x4 Payment 45,000 (7,143) (37,857)
31.12.x4 Year-end 0 82,858
31.12.x5 Interest ($50,000 x 2/21) 4,762
31.12.x5 Payment 45,000 (4,762) (40,238)
31.12.x5 Year-end 0 42,620
31.12.x6 Interest ($50,000 x 1/21) 2,381
31.12.x6 Payment 45,000 (2,381) (42,619)
31.12.x6 Year-end 0 1

Total interest 50,001

153
EXTRACTS FROM THE FINANCIAL STATEMENTS

Balance sheet

Non-current assets

Non-current assets held under finance leases 216,000

($240,000 x 9/10)

Long-term liabilities

Finance lease liability $156,191

Current liabilities

Finance lease liability $33,095

Income statement (extracts)

Depreciation on assets held under finance leases $24,000

Interest charges on finance lease liabilities $14,286

Notes to the financial statements

Included within creditors are finance leases with the following

minimum lease payments:

Payable within the next year $45,000

Payable between two and five years $180,000
Payable thereafter $0
Less: Future interest included in the above not yet due($35,714)
Total liability in the balance sheet $189,286

The net present value of lease payments due within the

following periods is:

(Note: this is the payments to be made, but excluding interest

that will become payable in that period).

Payable within the next year $33,095

Payable between two and five years $156,191
Payable thereafter $0
Total liability in the balance sheet $189,286

Proposals for change

154
The IASB has a long-term project to revise lease accounting for
the following reasons:

• The current distinction between operating lease and

finance lease is difficult to apply

• The distinction is seen by many as arbitrary

• The financial statements look very different depending on

whether there is a distinction of finance or operating
lease

• Operating leases clearly include an obligation to pay

rentals during the life of the lease. This obligation is not
currently recognised in the financial statements.

It is impossible to predict the likely outcome of the IASB

proposals as the project is in a very early stage. The IASB aim
to issue an exposure draft in the second half of 2008 but there is
no target date for a new IFRS on leasing.

Given the increasing focus on standards applying the principles

of the Framework, it seems likely that the new standard on
leasing will require that all leases over perhaps one year in
duration will be accounted for similarly to finance leases.

155
IAS 19: Employee Benefits

The need for the standard

Accounting for employment costs has proven over the years to

be one of the most controversial areas of financial reporting.
The aims of applying the matching principle and to avoid
reporting transactions that may give a misleading view of
sustainable profit have produced a number of accounting
standards that approach the problem in different ways.

For many entities, especially larger entities, post-retirement

costs can be a highly material component of both staff expenses
and also liabilities. In Trinidad and Tobago, many such pension
schemes are showing a surplus (which will be explained later).
This is less of a problem than many other companies have
around the world. In some cases, such as with British Airways,
the obligation to pay pensions to past and current employees is
of fundamental interest to analysts as the obligation is extremely
large and at the moment the pensions liabilities greatly exceed
the pension assets.

Consistency in recognition, valuation and reporting of staff costs

is clearly needed.

The latest edition of IAS 19 attempts to show the total cost of

employing a staff member in the current year by giving rules on:

• Recognition of accruals for unclaimed holidays

• Recognition of constructive but not legal obligations,

such as bonuses expected by staff

• Recognition of all post-employment costs in the period

where such benefits are promised, rather than when they
are paid (or even when contributions into a pension fund
are paid)

• Reporting gains and losses arising from changes in

assumptions about pension liabilities.

SHORT-TERM COSTS (IAS 19, paragraphs 10 – 23)

This mostly means all costs associated with employing

somebody in the current period other than post-employment (ie
pension) benefits. It may include:

• Salary

156
 • Employer’s taxes on employment such as social security
contributions

• Accrued bonuses, profit sharing and holiday leave

• Benefits paid on termination.

For the most part, accounting for short-term benefits is a

straightforward application of the matching/ accruals concept
and application of the requirements of IAS 37 Provisions.

Case study 19.1

Gahan Co employs 500 staff at an average remuneration of

USD 30,000 for 260 days’ paid annual remuneration. Average
annual leave is 15 days’ paid holiday per year plus five days
paid sick leave. Paid sick leave can be carried forward without
limits if unused. It can be taken without a requirement to prove
illness. Although the firm’s official policy is that all annual leave
not taken by 31 December each year is forfeited, it has always
been Gahan’s practice to allow staff to carry forward up to three
days’ unused paid annual leave each year-end. In the current
year, the average number of days of unused sick leave is two
days and unused holidays (limited to five for each person) is
2.5 days.

Staff are also paid bonuses each year of 10% of the company’s
profit before tax and before bonus expense. Without the
bonus, Gahan’s staff would be paid below market rates. The
company’s directors believe that they would face significant
difficulties with relationships with key staff if the bonus were not
to be paid. The current year’s profit (before bonus costs) is
USD 5.2 million.

Required

Calculate how each of the above items will affect profit for the
current year for Gahan Co.

Solution to case study 19.1

IAS 19 paragraph 15 requires that where sick leave is in

substance part of annual leave, the cost of providing it should be
accrued.

Unused sick leave: ($30,000/ 260) x 2,000 x 2 =

$115,385

157
Unused holidays: ($30,000/ 260) x 2,000 x 2.5 =
$144,231

Accrued bonus: 10% x USD 5.2 million =

$520,000

Total addition to short-term staff costs

$779,616

Case study 19.2

An entity has 100 employees, who are each entitled to five

working days of paid sick leave for each year. Unused sick
leave may be carried forward for one calendar year. Sick leave
is taken first out of the current year’s entitlement and then out
of any balance brought forward from the previous year (a LIFO
basis). At 31 December 20x1, the average unused entitlement
is two days per employee. The entity expects, based on past
experience which is expected to continue, that 92 employees
will take no more than five days of paid sick leave in 20x2 and
that the remaining eight employees will take an average of six
and a half days each.

Solution to case study 19.2

The entity expects that it will pay an additional 12 days of sick

pay as a result of the unused entitlement that has accumulated
at 31 December 20x1 (one and a half days each, for eight
employees). Therefore, the entity recognises a liability equal to
12 days of sick pay.

POST-EMPLOYMENT BENEFITS (IAS 19, paragraphs 24 –

143)

There are a wide variety of possible post-employment benefits,

such as the possible costs of guaranteeing to run a staff alumni
organisation. By far the most important post-employment
benefit is a contractual arrangement to pay a pension to
employees after they retire. This may be included as a term in
each person’s employment contract, or employees may opt into
a pension plan. Often, there is a qualifying period of a few years
before staff are entitled to opt into a pension plan.

There are two possible types of pension plan; one of which

presents few commercial risks and accounting difficulty and one
which presents considerable difficulty both for the company and
its accountants/ auditors. The distinction depends on what is
“defined” (ie known) from the contract with the staff member.

158
 Pension plans

Defined contribution Defined benefit

(Simple) (More complex)

Defined contribution plans (IAS 19, paragraphs 43 – 47)

In such a plan, the known factor is what level of contributions the

employer will make into a pension plan on behalf of the
employee. If the eventual retirement fund is too little to meet the
former employee’s needs, the employer has no ongoing legal or
constructive obligation to the employee. As such, as soon as
contributions are made into the pension plan, the employer is no
longer exposed to ongoing risk or involvement. For this reason,
the assets and liabilities of the pension plan are not reported on
the employer’s balance sheet, since they do not meet the
recognition criteria of the IASB Framework.

Accordingly, the only impact on the financial statements of the

employer is to record payments made into the pension plan on
behalf of the employee. The only liability is if there are
payments due that have not been paid.

It is unusual for there to be any significant time lag between the

employee providing their work and contributions being due for
payment. As a short-term liability any unpaid amounts are
therefore not discounted, since the effect of the discounting
would be immaterial. Paragraph 45 of IAS 19 requires that any
time lag of twelve months or more would be subject to
discounting to decide the net present value of the contributions
liability.

Note that throughout IAS 19, all pension plans must be held in a
separate fund from the sponsoring employer. This fund must be
a separate entity to the employer. This is to provide employees
and pensioners with protection in the event that the employer
runs into financial difficulty.

Defined benefit plans

159
Defined benefit plans used to be common in a number of
economies, including Trinidad and Tobago. They have become
significantly rarer in recent years as they have become a much
greater risk to employers than they were expected to be when
the obligations to employees were created, ie when the funds
were established. This is as investment performance has been
more variable than expected but also very largely as former
employees have lived materially longer after retirement than
expected when they joined the pension plan. This is referred to
as reduced mortality. Also, a number of pension plans have
terms which provide for care of former employees if they are
unable to work due to health. This risk of creating a greater cost
of expected lifetime care is referred to by actuaries as morbidity.
Both reduced mortality and greater morbidity have increased
total pensions payable to former employees in many companies.
The result of this perceived risk is that companies have largely
closed their defined benefit plans to new members, opting
instead to provide defined contribution benefits to staff. In the
Caribbean, rather against world trends, a number of defined
benefit plans are in surplus. There is still a risk to employers of
this reversing however and so we can expect defined benefit
plans to become less common in the future. Existing defined
benefit plans will continue to be a feature of the sponsoring
employer’s financial obligations however until the last pensioner
covered by each defined benefit plan dies.

The terms of a defined benefit plan are simply agreed between

employer and employee. This means that the terms can be
almost anything at all, ranging from the rather mean and
inadequate to the very generous. A typical defined benefit plan
will pay an annual pension (actually paid monthly but revised
annually for inflation) to the former employee from the date of
their retirement to the date of their death equivalent to:

Annual pension = Final salary x Years’ service for the employer

60

Case study 19.3

Pitt Co is a mining company. One employee, Brad, has

worked for the company for 25 years and is now reaching the
normal retirement age for the company of 55 years. At his
date of retirement, his “pensionable” salary (this would be
defined in his employment contract) was $16,500 pa. As part
of his employment contract, he has been a member of the
defined benefit plan for all of his working life with the
company. He has a defined benefit pension determined as
2% of his final pensionable salary for each year of service.
This is payable to him or to his wife until he dies. If he dies
with a surviving spouse, the pension plan rules provide that
50% of the pension benefit is payable to the surviving spouse
from the date of the former employee’s death to their own

160
death. The pension payable is adjusted each year for
inflation at the previous year’s inflation rate. Brad is married
to a 55 year old woman. In his country, male life expectancy
is 65 years for men and 71 years for women. As a former
miner, Brad’s life expectancy is expected to be two years less
than the average.

Required

Calculate the annual pension in today’s terms that Brad can

expect to receive.

Ignoring the time value of money, calculate the total expected

liability to Brad and his wife.

Solution to case study 19.3

Annual pension = Final salary x 2% x Years’ service for the

employer

$16,500 x 2% x 25 = $8,250

Brad and his wife can expect to receive $687.50 per month from
Pitt until the latter of them dies.

Brad’s remaining expected life from the date of his retirement is

8 years (65 – 2 – 55). His wife’s remaining life is expected to be
16 years.

Pitt therefore expects to pay (in today’s money) eight years of

pension of $8,250 and a further eight years to Brad’s wife of
$4,125. This makes a total liability of $99,000, ignoring the time
value of money.

Discounting liabilities

In reality, the time value of money will be very significant. In

order to meet the future liability above of $99,000 it will be
necessary to invest a substantially smaller amount today.

Each year that the employee performs further service for the
sponsoring employer, this will increase the pension eventually
payable to him/ her. The sponsoring employer will need to
invest further assets to meet this liability, although the time value
of money will be such that the extra amount needed to be
invested will be substantially smaller than the extra liability itself
as the funds can be prudently expected to grow at something at
least as fast as a risk free rate. This extra liability each year is
referred to in IAS 19 as current service cost.

161
In order to provide a prudent measure of the expected eventual
liability, paragraph 78 of IAS 19 requires that the liability to pay
future pensions is discounted at something only slightly above a
risk-free rate of return. The standard prefers the discount rate to
be used to calculate the NPV of the pensions liability each year
to be the yield on high quality corporate bonds. If there is no
deep market in such bonds, such as in Trinidad and Tobago, the
yield on government stock should be used. Paragraph 78 of IAS
19 requires that the currency of the bonds used to estimate a
risk-free rate shall be the same as the currency in which the
pensions are eventually payable. Sadly, this means that
reference to the yield on US government bonds is not an option
for a pension plan whose pensions are payable in Trinidad and
Tobago dollars.

It would appear that a typical real rate of return used by a

number of companies for such discounting is around 2.5% per
annum. This is very much a rule of thumb and should only be
used for discounting liabilities for smaller pension schemes
where the difference between this rule of thumb and a more
precisely determined estimate would not be material. If
possible, the real rate of return on long-dated bonds issued by
the government of Trinidad and Tobago should be used.

The discount rate used should be consistent with the basis upon
which the estimates have been prepared with respect to
inflation. For example, if all pensions payable have been
estimated using current prices without adjusting for the effects of
expected future inflation, these cash flows should be discounted
at a real rate rather than a “money” rate. The yield on
government bonds prevailing at any time is inherently a money
rate, since it logically also provides a return to cover current
inflation. Care must be taken to ensure that the assumptions
made with cash flows and discount rate are mutually compatible
(IAS 19, paragraph 72).

Case study 19.4

The pension payable to Brad in case study 19.3 was estimated

without making any allowance for future inflation. They are
therefore “real” cash flows which must be discounted at the
“real” rate, ie stripping out the effect of inflation when
calculating the current return on government bonds.

If the observed yield on government bonds (ie total return on a

bond bought at today’s market price) is observed at 9.8% and
inflation at today’s date is running at 7.0%, estimate the net
present value of Pitt’s liability to Brad at Brad’s retirement date.

162
Solution to case study 19.4

First, it is necessary to estimate an appropriate real discount

rate, using the function:

(1 + m) = (1 + i) x (1 + r), where m = money rate, i = inflation rate

and r = real yield on government bonds.

(1.098) = (1.07) x (1 + r)

=> r = 2.62%

This will then be used to discount the expected cash flows

payable to Brad (assuming one lump sum payment at the end of
each year for simplicity), with the following cash flows:

End of year 1 – end of year 8: $8,250 annuity (ie recurring

periodic payment)

End of year 9 – end of year 16: $4,125 annuity

The net present value of the above at 2.62% is $82,778. If the

same cash flows were to be discounted at the rates below, the
net present value would vary significantly:

• At 3.62%, the net present value would be $77,655

• At 5% the net present value would be $71,367

• At 9.8% (ie accidentally mixing real cash flows and

money discount rates), the net present value would be
$54,828.

Even relatively small changes in discount rate can therefore

affect the long-term liability significantly. Oddly, IAS 19 does not
require disclosure of the discount rate used to discount the
liability, nor any disclosure of how the liability in the balance
sheet would change if the discount rate were to move by 1%.

Interest cost

Each period, the liability comes one period closer to expected

settlement. It must therefore be compounded up by one year
using the discount rate used to initially discount it. This is
consistent in approach with “unwinding” discounts on liabilities
held at net present value under IAS 37. In the context of IAS 19,
this is referred to as “interest cost” although it is the same in
substance as unwinding of discounts under IAS 37.

163
Expected return on plan assets

In the same way that the liability will grow each period by the
effect of compounding the liability up by one period, the pension
plan’s assets will also be expected to grow by capital growth and
dividends received. IAS 19 requires that the plan assets each
year are compounded up by a long-term expected rate of
growth. The standard is silent on how to estimate this rate of
growth, so a long-term moving average appears to be the logical
choice. Any difference between the expected growth in the
plan’s assets and the actual growth forms part of the unexpected
(“actuarial”) gain or loss arising in the period. This is elaborated
below

Case study 19.5

Assuming that there is no change to estimates of expected

lives or discount rates, show the movements in the liability Pitt
Co has to Brad for the first year following his retirement.

Solution to case study 19.5

Liability brought forward $82,778

Add: Interest cost @ 2.62% $2,167

Less: Partial payment of liability (pension paid)

($8,250)

Liability carried forward $76,695

Actuarial gains and losses

In a defined benefit plan, the contractual duty of the sponsoring

employer is to pay future pension benefits. This creates an
obligation and an outflow of benefit so therefore a liability. This
is a long-term liability since virtually all of it will be paid more
than one year from the balance sheet date. It must therefore be
discounted at an appropriate rate, as the time value of money is
certain to be material.

The size of the liability is inherently uncertain, with its value

varying each period as each of these items may change:

• What each member’s final salary will be

• How long each person (or their dependants, if covered)

will live after they retire

164
 • Any other variables, such as additional health care costs
provided after retirement

• The appropriate discount rate to use in calculating the

net present value of the expected future cash outflows.

Changes in each of these estimates will cause a change in the

net present value of the liability to pay future pensions. Such
changes, even for a pension fund with no new members, can be
highly material.

In order to meet the liability for future pensions payable, almost

all pension funds (the notable exception being almost all state
pension plans) will also have a separate legally protected fund to
hold the pension plan assets. There may be rules either in law
or in the pension plan’s own rules that govern what type of
investments the pension plan may make. Typically, trustees of a
pension plan are only allowed to invest in lower risk investments
and may be prevented from investing in the sponsoring
employer’s own shares.

If all goes to plan, the assets in the pension plan will grow to
exactly meet the money needed to pay the employees their
future pensions between when they retire and when they die.
This inevitably never happens.

In reality, each year it is highly likely that the assets and the
liabilities will be out of balance, producing an actuarial gain or
loss (surplus or deficit). This type of gain is referred to as an
actuarial gain, since it arises as a balancing items from the
complex calculations made about expected future returns, life
expectancy of pensioners and many other complicated matters
that are best performed by a professional actuary. IAS 19 does
not require that a pension plan is valued by an actuary, but it
requires disclosure of who performed the valuation. In any large
pension plan, it is likely that analysts would not trust figures on
such a complicated discounted cash flow analysis if that is
prepared by the directors.

Case study 19.6

Consider the implications for the pension plan of Pitt Co in each

of the following circumstances. Would each of these changes
one-by-one be likely to produce an actuarial gain (ie surplus) or
loss (ie deficit)?

a. A more up-to-date survey shows that both male and

female life expectancy are now two years higher than
previously thought

b. A significant number of the employees are found to be

living with HIV

c. Long-term investment returns increase to be 1% higher

than previously estimated

165
 d. It is discovered that the workforce covered by the
pension plan is 40% female, where the actuary had
wrongly assumed it to be 50/50 split.

In each case, consider separately the effect, if any, on the net

present value of the pensions liability and then the effect, if any,
on the value of the pension plan’s assets.

Solution to case studies 19.6a – 19.6d

19.6.a. This would have no effect on the pension plan’s assets,

but would increase the period for which pensions are
expected to be paid. It would therefore generate a new
actuarial deficit (loss).

19.6.b. This would have no effect on the pension plan assets.

The results of this on the pension plan liability are
uncertain. HIV if untreated is likely to significantly reduce
life expectancy. This would therefore reduce the total
pension payable and produce an actuarial surplus, as the
pension payable would be less than previously
estimated. However, if the pension plan includes health
care cover, then the cost of HIV combination therapy
could be a very substantial additional morbidity cost.
This would then produce a substantial actuarial deficit
(loss). The precise effects of each change in actuarial
assumptions can only be determined with full knowledge
of the rules of the pension plan itself.

19.6.c. This would have no effect on the pensions liability, but

would increase the expected return on plan assets. As
the plan assets at the end of the year would be greater
than expected, it would create a new actuarial surplus
(gain).

19.6.d. As female life expectancy is greater than male, a lower

proportion of female workers to male would reduce total
pensions payable and thus reduce the pensions liability
below what was previously estimated. As it would have
no effect on the pension plan assets, this would generate
a new actuarial surplus (gain).

Case study 19.7

Assume that at the end of Brad’s first year of retirement, the life
expectancy of both he and his wife have both risen by two
years.

Required

Estimate the new pensions liability at the real discount rate of

2.62%.

166
Solution to case study 19.7

The new cash flows expected to be payable would be

(remembering that this is now one year later than the first
actuarial valuation of the liability to Brad):

End of year 1 – end of year 9: $8,250 annuity (ie recurring

periodic payment)

End of year 10 – end of year 17: $4,125 annuity

The net present value of the above at 2.62% is $88,704.

This would have an unexpected effect on the year-end liability to

Brad:

Liability brought forward $82,778

Add: Interest cost @ 2.62% $2,167

Less: Partial payment of liability (pension paid)

($8,250)

Liability carried forward (expected) $76,695

Add: Actuarial loss in year $12,009

Liability carried forward (actual) $88,704

Variability of actuarial assumptions

Actuarial assumptions can vary year by year. For this reason, it

may be distorting to a view of sustainable profit to report all
actuarial gains and losses arising each year in profit.
Experience suggests that this could produce large credits one
year, only to be countered by large debits the year after. This is
especially the case with variations in discount rates, since these
vary up and down with the economic cycle.

IAS 19 therefore allows companies a choice of accounting policy

for dealing with cumulative actuarial gains and losses, being
either:

• Only report gains outside a 10% “corridor” in each year’s

profit. This allows a pension plan to swing into surplus or
deficit by 10% of the size of the pension plan without
these actuarial gains or losses being reported in profit, or

167
 • Report all actuarial gains or losses arising each year in
full but bypass the income statement and report them
directly in the statement of changes in equity.

The 10% figure is somewhat arbitrary and is determined as the

larger of 10% of the fair value of the pension fund’s assets at the
start of the period and 10% of the net present value of the
pension fund’s liabilities at the start of the year.

Profit smoothing

IFRS generally try to prohibit profit smoothing techniques that

have been used in the past, such as making and releasing
unnecessary provisions. IAS 19 allows, and indeed requires, a
sponsoring employer to take certain profit smoothing steps. This
is sensible as with a pension plan where liabilities are very long-
term and where a large number of different variables can affect
the snapshot value of assets and liabilities each year. The long-
term nature of a pension plan means that gains and losses can
be viewed as unrealised for a longer period than normal
provisions could. For example, an unusually strong
performance in pension fund investments in the current year is
likely to become a much weaker performance in the future
before the liability to pensioners is extinguished.

To minimise disruption to the income statement of the

sponsoring employer, IAS 19 therefore requires:

• Either all actuarial gains or losses to be reported in full in

equity as incurred, or only gains outside the 10% corridor
to be reported in income statement.

• If the income statement with 10% corridor approach is

used, any gain or loss outside this 10% limit may be
amortised over the remaining service life of staff.

• Current year gain in pension fund assets reported in the

income statement is a long-term average expected return
on plan assets rather than the actual current year
increase in plan asset value.

• Any increases in pension plan benefits with retrospective

effect (“past service costs”) are amortised over the
remaining service life of staff. This is not possible where
pension benefits are enhanced for people who have
already retired, as there is no period of benefit to match
this cost to.

Curtailments (IAS 19, paragraphs 109 – 115)

168
Where a sponsoring employer is able to reduce pension benefits
payable under a pension plan this will produce an immediate
actuarial gain, or at least reduction in deficit. A curtailment could
occur where it becomes apparent that the sponsoring employer
is not a going concern with the ongoing pension liability or where
a division is sold or closed down. An employer may also be able
to transfer the pension obligation to a third party such as an
insurance company which may generate a gain on the
derecognition of all the pension plan’s assets and liabilities. The
figures for the pension plan must be revalued immediately
before the curtailment using the most up-to-date actuarial
assumptions and treated in accordance with the normal rules of
IAS 19. By doing this, only the effects of the curtailment itself
are reported in the income statement.

In the event of such a curtailment happening, the difference

between the net balance sheet position before the curtailment
and after the curtailment is reported in the income statement
immediately as a gain or loss.

Disclosures

There are substantial disclosure requirements of IAS 19. To

comply with these, it is best to read the IAS itself. Broadly, all
components of the net balance sheet position and all
movements in these figures are required to be shown. The
comprehensive case study below provides an example of the
principal disclosures.

COMPREHENSIVE CASE STUDY

Derry, a public limited company, operates a defined benefit plan.
A full actuarial valuation by an independent actuary revealed
that the value of the liability at 31 May 20x4 was $1,500 million.
This was updated to 31 May 20x5 by the actuary and the value
of the liability at that date was $2,000 million. The scheme
assets comprised mainly bonds and equities and the fair value
of these assets was as follows:

31 May 20x4 31 May 20x5

$m $m
Fixed interest and index linked bonds 380 600
Equities 1,300 1,900
Other investments 290 450
_____ _____
1,970 2,950
_____ _____
The scheme had been altered during the year with improved
benefits arising for the employees and this had been taken into
account by the actuaries. The increase in the actuarial liability in
respect of employee service in prior periods was $25 million

169
(past service cost). The increase in the actuarial liability
resulting from employee service in the current period was $70
million (current service cost). The company had not recognised
any net actuarial gain or loss in the income statement to date.

The company had paid contributions of $60 million to the

scheme during the period. The company expects its return on
the scheme assets at 31 May 20x5 to be $295 million and the
interest on pension liabilities to be $230 million.

The average expected remaining working lives of the employees

is 10 years and the net cumulative unrecognised gains at 1 June
20x4 were $247 million.

The company wishes to use the corridor approach but minimise

impact of the pension plan each year on its reported profit.

Solution to comprehensive case study

IAS 19 “Employee Benefits” concentrates on a balance sheet

perspective for employee benefits and focuses on the use of
current values. The surplus or deficit in the fund is to be
determined annually with assets being measured at their fair
value at the balance sheet date. The scheme liabilities should be
measured on an actuarial basis using the projected unit credit
method and a corporate bond rate to discount the obligations.
The net amount appears in the employers’ balance sheet as an
asset or liability.

Full actuarial valuations should occur with sufficient frequency

such that financial statement amounts do not differ materially
from amounts that would be determined at the balance sheet
date. The balance sheet asset cannot exceed the net total of

(a) unrecognised actuarial losses and past service cost, and

(b) the present value of any available refunds from the plan
or reduction in future contributions to the plan

Gains and losses measured at the year end are reflected in the
subsequent year. The amortisation of the net gain/loss is
required if it is in excess of 10% of the greater of the defined
benefit obligation or the fair value of the plan assets. The period
of amortisation cannot exceed the average remaining service
period.

Plan amendments which result in a change in the past service

cost for active employees is recognised on a straight line basis
over the average remaining vesting period.

Companies are concerned about the volatile nature of charges

in the income statement in the form of the expected return on
plan assets as the higher the asset value of equities then the

170
higher will be the “expected return on assets” figure. If the equity
market is volatile, then so will be the expected return figure.

IAS 19 offers a choice of possibilities of how to deal with the

amount of profit/losses not recognised in the income statement.
The actuarial gains/losses can be deferred if the cumulative
amount remains inside the 10% corridor. Any amount outside
the corridor (and optionally any amount inside) can be amortised
over a shorter period than the working lives of the employees or
even immediately so long as the approach is consistent.

An amendment to IAS 19 issued in December 2004 allows a

further option in accounting for the actuarial gains and losses.
The amendment allows an entity to recognise all of the actuarial
gain or loss immediately through the statement of changes in
equity. If an entity wishes to adopt this policy then they must do
so for all defined benefit plans and all actuarial gains and losses.

Suggested approach
Working through each of the three balance sheet asset or
liability accounts in double entry is probably the best way to see
each transaction. In order these are:
1. Look at the previous year’s unrecognised actuarial gain
or loss (if using the corridor limit approach). If using this
approach, calculate how much of the opening actuarial
gain or loss is outside the corridor limits. Apply the
company’s accounting policy to this (eg amortise over
remaining service life of employees).
2. Calculate interest cost and add to pensions liability (Dr
income statement, Cr liability)
3. Calculate expected return on plan assets and add to plan
assets (Dr pension plan assets, Cr income statement)
4. Record any contributions to the plan (Dr pension plan
assets, Cr company cash)
5. Record any pensions paid to former pensioners (Dr
pensions liability, Cr pension plan assets)
6. Record extra liability to staff for one more year of service:
current service cost (Dr income statement, Cr pensions
liability)
7. Record extra liability for pension plan members for
service already given, such as enhancements to benefits:
past service cost (Dr deferred past service costs and/ or
income statement, Cr pensions liability)
8. Compare the theoretical balance on pensions liability and
pension plan assets and compare to actual. The
differences are actuarial gains arising in the year.
9. Calculate carried forward balance on deferred actuarial
gains or losses.

171
 10. Prepare necessary disclosures, including adding total of
plan assets, pensions liability and unrecognised actuarial
gain or loss to show one-line presentation of net
recoverable or payable to the pension plan in the
sponsoring company’s balance sheet.

Pension plan liability

31.5.x5 Pensions paid 0 31.5.x4 Brought down 1,500

31.5.x5 Past service costs 25
31.5.x5 Carried down 2,000 31.5.x5 Current service costs 70
(advised by actuary) 31.5.x5 Interest 230
31.5.x5 Actuarial loss (balance) 175

2,000 2,000

Pension plan assets

31.5.x4 Brought down 1,970 31.5.x5 Pensions paid 0

31.5.x5 Contributions 60 31.5.x5 Carried down 2,950
31.5.x5 Expected return 295
31.5.x5 Actuarial gain 625

2,950 2,950

Actuarial gain unrecognised in profit (deferred on balance sheet)

31.5.x5 Income statement (w) 5 31.5.x4 Brought down 247

31.5.x5 Pension liability 175 31.5.x5 Plan assets 625
31.5.x5 Carried down 692

872 872

Balance sheet note

31 May 20x5
$m
Present value of the obligation 2,000
Fair value of plan assets (2,950)
_____

172
Net surplus in plan 950
Unrecognised actuarial gains (692)
_____
Net plan asset in sponsoring employer’s balance sheet 258
_____

The net plan asset is subject to a test to ensure that it does not
exceed the future economic benefit that it represents for the
enterprise.

Income statement note 20x5

$
Current service costs 70
Interest cost 230
Expected return on plan assets (295)
Net actuarial gain recognised in the year (5)
Past service cost 25
–––––
Income statement expense 25
–––––

Note: As the benefits are vested immediately following an

alteration to the plan, the past service cost is recognised
immediately.

WORKINGS

(1) Corridor limits from previous year and recognition of

previous year actuarial gain or loss outside corridor limit

At 1 June 20x4

173
 $m
Net unrecognised gain 247
Limits of 10% corridor
(greater of 10% of 1,500 or 10% of 1,970) (197)
_____
Excess 50
_____
Amortisation is therefore (50 ÷10 years) 5
_____
This will be recognised as Dr unrecognised gains 5, Cr income
statement 5.

(2) Actuarial (gain)/loss

On obligation 20x5
$
Present value of obligation at 1 June 20x4 1,500
Interest cost 230
Current service cost 70
Past service cost 25
–––––
Expected value* 1,825
Actuarial (gain)/loss – a balancing figure 175
–––––
Present value of obligation at 31 May 20x5 2,000
–––––
* this is what the valuation would show if all of the estimates
made at the start of the period had been 100% accurate

On asset 20x5
$
Market value of plan assets at 1 June 20x4 1,970
Expected return on plan assets 295
Contributions 60
–––––
Expected value * 2,325
Actuarial gain/(loss) – a balancing figure 625
–––––
Market value of plan assets at 31 May 20x5 2,950
–––––
* this is what the valuation would show if all of the estimates
made at the start of the period had been 100% accurate

Actuarial gains and losses 20x5

$
Gain/(loss) on the obligation (175)
Gain/(loss) on the asset 625
–––––
Net 450
–––––

174
Amount of actuarial difference recognised 20x5
$
b/f 247
Gain /(loss) in the year (see (a) above) 450
Recognised in the period (W) (5)
–––––
Net gain unrecognised at the year end 692
–––––

Corridor limits for recognition of gain in year ended 31.5.x6

$
10% of plan obligations at the start of the year 200
10% of plan assetsat the start of the year
295
–––––
Limit is the greater of the above 295
–––––
Actuarial gain at year end 692
Amount which falls outside the corridor 397
–––––
Amount recognised next year (÷ 10) 40
–––––

175
IAS 21: Effects of Foreign Exchange Rates

The need for the standard

Clearly, many businesses will engage in transactions

denominated in foreign currencies and so some uniformity in the
treatment of foreign currency transactions and exposures is
essential.

IAS 21 covers a number of situations where a business may

become exposed to changes in foreign exchange rates:

• Transactions of the reporting entity in a foreign currency,

eg by raising a loan in a foreign currency or by making
sales to a foreign customer where the sale price is
denominated in the foreign currency.

• Having a foreign branch or subsidiary.

• The entity wishing to report its results in a different

currency to the currency in which it principally operates,
perhaps to attract US investors.

The standard covers each of these situations and provides

detailed guidance on how each situation should be presented.

Outside scope of standard

IAS 21 does not cover foreign currency derivatives, which may

include relatively common foreign currency risk management
techniques such as forwards. These are covered by IAS 39.

IAS 21 no longer contains rules about presentation of hedged

transactions. These are also covered by IAS 39.

Principal changes to the previous IAS 21

Accounting for the effects of foreign currency transactions has

been revised a number of times, with the most recent version of
IAS 21 taking effect from 1 January 2005.

The latest version of IAS 21 makes a number of fundamental

changes to the previous version, including the introduction of the
critically important concept of entities having to determine, as
objectively as possible, which is their functional currency.

The standard no longer has any concept of a closing rate

method and temporal methods of translation of foreign
subsidiaries.

176
It is no longer possible for a company in a hyperinflationary
economy to avoid the need to restate figures under IAS 29 by
instead choosing that it shall record all transactions in a stable
currency, unless that stable currency can fairly be described as
the entity’s functional currency (see below).

Anybody familiar with the previous version of IAS 21 is well

advised to study the latest version assuming no prior knowledge.
Much of it will be familiar but much will not be.

Critical technical terms

Foreign currency A currency other than the functional

currency of the entity.

Functional currency The currency of the primary economic

environment in which the entity
operates. See below for further
discussion of this.

Monetary items Units of currency held and assets and

liabilities to be received or paid in a
fixed or determinable number of units
of currency. Examples are
receivables, payables and foreign
currency deposits. Non-monetary
items include non-current assets and
goodwill.

Presentation The currency in which the financial

currency statements are presented.

Spot exchange rate The exchange rate for immediate

delivery.

Suggested approach to foreign currency

These terms will be defined later, but it may help to give an

overview of a suggested approach to foreign currency
transactions:

1. Decide which is the entity’s functional currency. Review

this annually to ensure it is still the most appropriate
choice.

2. Translate any transactions in foreign currency to the

entity’s functional currency as they occur at the spot rate

3. At the year-end, revalue monetary items to the closing

rate with the ensuing gain or loss reported in the income
statement

177
 4. Translate the financial statements from the functional
currency to a different reporting currency, if required.

Key issue: Determination of functional currency

Trinidad and Tobago law requires that the accounting records

are maintained in Trinidad and Tobago dollars. This can be
rather onerous for branches of foreign entities where much of
the income and expenses are not in the local currency.

IAS 21 requires that each entity makes a formal assessment of

which is its functional currency. This is step one in dealing will
all foreign currency is critical as it decides which one currency in
the World is not a foreign currency!

Deciding which is the functional currency is a matter of

professional judgement, possibly weighing up opposing factors.
In practical terms, it is probably the currency that most people
working in the business use to refer to transactions.

Paragraphs 9 – 12 of IAS 21 give a number of factors that an

entity should consider in deciding which is its functional
currency, given below.

Primary factors to consider (give these a high weighting):

• The currency that mainly influences sales prices for

goods and services, which will often be the currency in
which transactions are denominated and then settled

• The currency of the country whose economy mainly

determines the sales prices of its goods and services.

• The currency that mainly influences costs of inputs, such

as labour and materials.

Secondary factors to consider (give these a lower

weighting):

• The currency in which debt is raised to fund the business

• The currency in which sales receipts are usually retained

• Whether the activities of the entity are, in substance, a

direct extension of the activities of a foreign parent. This
would imply that the functional currency of the branch is
the same as the functional currency of the parent.
Indicators of such a closely tied parent-branch
relationship include:

178
 o Commercial decisions such as pricing and
arranging borrowings all done by the parent
company

o If transactions with the parent are a high

proportion of the local entity’s trading

o If the local entity is not a going concern without

transactions with the parent entity.

Once an entity has determined which is its functional currency,

this is not changed unless there is a clear need to do so.

It is therefore possible for an entity to have to deal with foreign

currency in two stages, for example with a company whose
functional currency is TTD buying some goods in EUR if that
company is choosing to report in USD with a view to flotation on
the New York Stock Exchange.

Initial recognition and subsequent gains and losses

(paragraphs 20 – 34 IAS 21)

Foreign currency transactions must be translated at the spot rate

on the date of the transaction into the functional currency from
the foreign currency. This is the date when the item would first
be recognised in the IFRS accounts. For acquisition of an asset,
this is normally the date from which it is possible to control the
asset. For a liability, it is the date from which an obligating event
exists.

At the end of each reporting period, monetary assets and

liabilities are retranslated at the year-end rate. Any gain or loss
arising on this retranslation is reported in full in the income
statement. Changes in the exchange rate after the balance
sheet date do not represent an adjusting event after the balance
sheet date.

Non-monetary items are not retranslated if they are held at

historic cost. If they are held at fair value, for example
investment property, they are retranslated at the rate ruling on
the date that the latest fair value was established. This includes
a fair value for items that must be checked to ensure that their
historic cost does not exceed net realisable value, such as
inventory.

Exchange differences are generally reported in the income

statement, although if a gain or loss on a non-monetary item is
required by another IAS/ IFRS to be shown directly in equity,
then the foreign currency gain or loss is also shown in equity.

179
Case study 21.1: Choice of functional currency

Leonard Co is a holiday company which owns a number of

villas it purchased or constructed in Tobago. The company is
owned by a private equity group in the UK. Around 75% of its
principal income stream is US Dollars, with a significant but
smaller element of its income in Euro. It generates little income
in Trinidad Dollars and only a small proportion of its expenses
are in Trinidad Dollars as most of its expenses are interest to
service the US variable rate loans to purchase the property and
agents’ fees in the USA and the Euro zone.

It financed the purchase or construction of the villas it rents with

variable rate interest only mortgages in US Dollars from US
banks.

In order to comply with Trinidad revenue law, it maintains its

records in Trinidad Dollars. In order to appear locally sensitive
and to avoid having to keep separate accounting records in
Trinidad and Tobago dollars so as to comply with Trinidad
revenue law, it has declared the Trinidad Dollar to be its
functional currency.

The key figures from the balance sheet and income statement
of the company show the following:

20x2 20x1

Non-current assets TDD 280 m TDD 260 m

Mortgages loans USD 45 m USD 45 m

Other net assets TDD 40m TDD 36 m

Half of the other net assets are monetary net assets and half
are non-monetary net assets. The exchange rate ruling when
the properties were purchased was TDD/USD = 8.2 and the
rate ruling when the non-monetary other assets were incurred
was TDD/USD = 6.8.

You are told that the exchange rates between the US Dollar
and the Trinidad and Tobago Dollar were (fictitious):

31 December 20x1: TDD/ USD 8.0

31 December 20x2: TDD/ USD 6.0

Average for the year 6.8

Required

Using the Trinidad Dollar as the functional currency, produce

the balance sheets of the company at 31 December 20x1 and

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31 December 20x2 and the income statement for the year
ended 31 December 20x2. Calculate foreign exchange gains
and losses.

Reperform the above calculations using the USD as the

functional currency. Comment on the results. Decide, with
reasons, whether the choice of functional currency was
appropriate.

Case study 21.2

This case study gives an overview of a number of requirements

of IAS 21.

Suppose Company A is based in Trinidad. It decides that its

principal exposure is to the Trinidad economy, with some
limited purchases and sales abroad. It chooses to report its
results both in TDD and in USD.

On 15 November 20x6, it bought some specialist raw materials

from a company in Germany. These had a price of EUR
45,000, which was to be settled in Euro. The exchange rate on
this date was TDD/EUR = 7.652.

At the year end of 31 December 20x6, this debt had not been
paid although no penalty interest was payable. The debt was
eventually paid on 1 February 20x7.

The exchange rates between the TDD, EUR and USD on the
relevant dates were:

TDD/EUR TDD/USD

31 December 20x6 7.976 6.150

Average for 20x6 7.820 6.185

1 February 20x7 7.860 6.075

Required

Calculate the gain or loss in the entity accounts of the Trinidad

business in the years to 31 December 20x6 and 31 December
20x7.

181
Suggested solution

15 Nov 20x6

The purchases and the associated liability will be recorded at the

spot rate between the foreign currency and the functional
currency on this date, being TDD/ EUR = 7.652.

Dr Purchases TDD 344,340

Cr Payables TDD 344,340.

31 Dec 20x6

The inventory is a non-monetary asset so it is not retranslated at

the period-end closing rate, but rather left at its historic rate.
The payable is a monetary item so must be retranslated at the
period-end closing rate. This means that the payable is now
valued at TDD 368,920 (EUR 45,000 x 7.976). This produces a
foreign exchange loss:

Dr Foreign exchange loss in income statement TDD 24,580

Cr Payables TDD 24,580.

1 Feb 20x7

When the payable is settled, it will be necessary to spend TDD

353,700 to buy EUR 45,000 (45,000 x 7.860). There is therefore
a final foreign exchange gain on derecognition of the payable:

Dr Payables TDD 368,920

Cr Cash TDD
353,700
Cr Exchange gain in income statement TDD 5,220.

Change in functional currency (IAS 21 paragraphs 35 – 37)

If the company changes its functional currency, which should be

rare, then the new currency is applied only prospectively rather
than retrospectively. All the figures in the old functional currency
are translated into the new functional currency at the date of the
change.

Translation from functional currency to presentation

currency
(IAS 21, paragraphs 38 – 47)

For most smaller and medium-sized entities, this stage will not
be required. This additional step will be required for larger
business that either:

• Have a foreign subsidiary which has a different functional

currency to the parent, or

182
 • Where the company chooses to present its financial
statements in another currency to its own functional
currency (eg if listed on a foreign stock exchange).

The more common situation is the former, where a parent will

wish to translate the accounts of its subsidiary or associate into
its own presentation currency prior to consolidation. The
techniques are the same, however.

Paragraph 39 of IAS 21 contains the main rules:

The results and financial position of an entity whose functional

currency is not he currency of a hyperinflationary economy shall
be translated into a different presentation currency using the
following procedure:

• Assets and liabilities for each balance sheet presented

(ie including comparatives) shall be translated at the
closing rate at the date of that balance sheet;

• Income and expenses for each income statement (ie

including comparatives) shall be translated at exchange
rates at the dates of the transactions; and

• All resulting exchange differences shall be recognised as

a separate component of equity.

It is normal and permissible to use an average rate for

translation of the income statement, so long as the exchange
rate between functional currency and presentation currency has
not been unusually volatile in the period.

Case study 21.3

Lime Co is a company based in Trinidad. It uses the Trinidad

and Tobago dollar as its functional currency. It chooses to
publish financial statements both locally and also in US Dollars,
with a view to attracting investment from US companies. It
performs this translation in accordance with IAS 21.

You are provided with the income statement for the year ended
31 December 20x6, the balance sheet at this date and also the
previous year’s balance sheet. You are told that the average
mid-market exchange rate between the Trinidad and Tobago
dollar and the US dollar recently has been:

31 December 20x6: 6.75

31 December 20x5: 7.00

Weighted average for 20x6: 6.50

183
Required

Using the data above, present the financial statements in US

Dollars. Calculate exchange differences that will be analysed
as a separate component of equity.

Solution to case study 21.3

Income statement for the year ended 31 December 20x6

Ex
TDD'
000 rate USD'
000

Revenue 48,000 6.50 7,385

Cost of sales (25,000) 6.50 (3,846)
Gross profit 23,000 3,538
Operating expenses (12,000) 6.50 (1,846)
Finance costs (2,000) 6.50 (308)
Profit before tax 9,000 1,385
Tax (2,700) 6.50 (415)
Profit after tax 6,300 969

Net Assets at 31 December 20x6

Ex
TDD rate USD

Freehold land 17,000 6.75 2,519

Inventories 8,300 6.75 1,230
Receivables 10,000 6.75 1,481
Cash 15,000 6.75 2,222
Total assets 50,300 7,452

Trade payables (12,000) 6.75 (1,778)

Loans (9,000) 6.75 (1,333)

Net assets 29,300 4,341

Net Assets at 31 December 20x5

Ex
TDD rate USD

Freehold land 17,000 7.00 2,429

Inventories 7,500 7.00 1,071
Receivables 10,000 7.00 1,429
Cash 10,500 7.00 1,500
Total assets 45,000 6,429

Trade payables (11,500) 7.00 (1,643)

Loans (10,500) 7.00 (1,500)

184
 Net assets 23,000 3,286

Proof of exchange difference

Closing equity 29,300 4,341

Opening equity 23,000 3,286
Increase in the period 6,300 1,055

Explained by:
Profit after tax in year
Items taken directly to equity:
Shares issued/ redeemed
Revaluation gains
Dividends
Forex difference (residual
item)
6,300 969
0 0
0 0
0 0
0 86

In this situation, the translation to the reporting currency has

produced a credit to reserves of $86,000. As this arises only as
a result of rounding errors rather than being a truly realised loss
to the shareholders, it is reported directly in equity rather than
being reported as an expense in the income statement. As it
does not represent a true loss, it is not subsumed within retained
earnings, since to do so would imply that it’s a true realised loss.
Instead, it is reported as a separate component of equity.

Consolidation of a foreign operation/ subsidiary (IAS 21

paragraphs 44 – 47)

Note: If you are unfamiliar with group accounting, you should

work through ICATT’s notes on IFRS 3 and IAS 27 before
working through the example below.

This is a modification of the method used to translate into a

reporting currency as given above. There are some additional
matters that are likely to arise where there is a foreign entity to
consolidate, including:

• Goodwill on the acquisition of the foreign operation

• Fair value adjustments made in the calculation of this
goodwill
• Cancellation of intra-group balances between the
domestic and foreign operations.

Goodwill, trading impairment and forex impairment (IAS 21,

paragraph 47)

Goodwill on the acquisition of another business arises in the

books of the acquiring company on consolidation (as on
consolidation the historical cost of the investment is
decomposed into the net assets of the subsidiary date at
acquisition and goodwill at acquisition). Goodwill represents the

185
premium that was paid to the previous owner of the acquired
business for the right to receive all (or a controlling share) of the
expected future profits of the acquired entity.

Case study 21.4

Auto GmbH is a German company whose functional and

reporting currency is the Euro. On 1 January 20x1, it bought
an 80% interest in Coche SARL, a Spanish company whose
functional and reporting currency is also the Euro. Auto paid
the previous owners of Coche EUR 125 million for this
controlling interest. At the time, the net assets of Coche at fair
value were EUR 120 million.

This would be recorded in the entity balance sheet of Auto as a

simple investment, thus:

Dr Investment in Coche EUR 125 million

Cr Cash, loans, new shares, etc EUR 125 million.

Looking at what has come into and out of the group balance
sheet of Auto, this cost of investment is decomposed into the
individual assets and liabilities of the subsidiary, minority
interest that must now be recorded and goodwill as a residual
figure. The changes to the group balance sheet will therefore
be:

Dr Individual assets/ liabilities EUR 120 million

Cr Minority interest (20% above) EUR 24 million

Cr Cash, loans, new shares, etc EUR 125 million

Dr Goodwill (residual) EUR 29 million.

Goodwill never arises in the books of the subsidiary itself, but

always in the books of the acquirer, as noted above.

The acquirer is therefore buying a non-monetary intangible non-

current asset when it acquires goodwill. This asset is of a highly
uncertain value, especially if it is acquired in a foreign currency.
The actual value of the future income stream (share of profits of
the subsidiary) can be affected by both:
Poorer than anticipated performance of the subsidiary, and
Exchange rates moving adversely to mean that the remitted
value of the profits of the subsidiary are lower than originally
expected.

There are therefore two stages to the impairment review of

goodwill on a foreign operation. Any impairment review
performed on the trading performance of the foreign entity will
be treated as a realised loss and reported in the income
statement of the parent, in accordance with IAS 36. This is

186
because there is a reasonable degree of certainty that the ability
of the subsidiary to generate income in its own functional
currency has been impaired.

Additionally, the parent is now required to look each period for

any unrealised impairment loss due to foreign currency
movements. Often an adverse movement in the exchange rate
between the functional currency of the foreign operation and the
functional currency of the parent will reverse in future years.
Any such impairment is initially therefore considered to be an
unrealised impairment (or gain) and is reported in equity of the
parent company.

Fair value adjustments (IAS 21, paragraph 47)

As fair value adjustments are an integral part of the goodwill

calculation and goodwill is considered to be an asset in the
functional currency of the foreign entity, fair value adjustments
are also considered to be a foreign currency asset or liability and
retranslated each year at the closing rate. This includes fair
value adjustments on non-monetary assets, as all assets and
liabilities of the subsidiary are translated at the closing rate.

Intra-group balances (IAS 21, paragraph 45)

Intra-group items are payables or receivables and are thus

inherently monetary items. All monetary items must be
translated at the closing rate.

Case study 21.5

Parent Co is a British company whose functional currency and

reporting currency is GBP. It has a subsidiary in the USA,
whose functional currency is the USD.

During the current year on a date when the spot rate was
USD/GBP = 2.0, Parent sold inventory to Subsidiary for a sales
price of GBP 100,000. These goods were not paid for by
Subsidiary at the time although the intention was for Subsidiary
to remit GBP 100,000 to Parent before long. This was not
intended by Parent to be part of Parent’s long-term investment
in Subsidiary.

On the initial transfer, Parent correctly recorded the following:

Dr Intragroup receivables GBP 100,000

Cr Intragroup sales GBP 100,000.

On the same date, Subsidiary correctly recorded the following:

Dr Intragroup purchases USD 200,000

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Cr Intragroup payables USD 200,000.

At the year-end, the exchange rate was USD/GBP = 2.5.

Translating the intragroup payable of USD 200,000 at this rate
produces the following balances:

Intragroup receivable (in books of Parent) GBP 100,000

Intragroup payables (in books of Subsidiary) GBP 80,000.

The two figures do not cancel. This is not due to items in

transit since both entities have correctly recorded transactions
and are up to date. The transaction requires that Subsidiary
buys GBP 100,000 to pay its liability to Parent. At the year-end
rate, this will cost Subsidiary USD 250,000. Applying the
normal rules of translation of foreign currencies, Subsidiary will
have retranslated its liability of GBP 100,000 to USD 250,000
generating a foreign currency loss in its own books of USD
50,000. At the year-end rate, this gives a foreign currency loss
of GBP 20,000.

This currency loss must be recognised, even if the foreign

operation is consolidated using interim financial statements
which have not had monetary items translated to the year-end
rate. It is reported in the income statement of Subsidiary as a
loss in the income statement and so also a loss in the group
income statement.

The only exception to this requirement to show losses on

retranslation of intra-group balances is if the parent has
advanced a long-term loan to the foreign operation which it does
not seek recovery of in the near future. This would then form
part of the cost of the foreign operation.

Case study 21.6

On 1 January 20x6, Bush Co (a US company with functional currency USD)

purchased an 80% controlling interest in Williams Co when the exchange rate was 8
Trinidad dollars per US dollar. It paid USD 405,000 for this controlling interest.

At this date, the capital of Williams was TDD 1.5 million and Williams had retained
earnings of TDD 1.46 million. There were no recognised impairments of this goodwill
on acquisition in the year to 31.12.x6.

The exchange rate at 31 December 20x7 was 6.75 TDD per USD, at 31 December
20x6 it was 7 and the average rate during the year to 31 December 20x7 was 6.50.
The average rate in the year to 31 December 20x6 was 7.25. Dividends were
declared at the end of the year and were paid shortly after the year-end. No
dividends were paid in the year to 31 December 20x6. Williams made a profit in the
year to 31.12.x6 of TDD 1,827,000. On 31.12.x7 an impairment review of the
subsidiary, which is considered to be a single cash generating unit under IAS 36
showed an impairment of TDD 174,400, all of which has been allocated to the
goodwill on acquisition.

188
Note: These figures have been calculated using a spreadsheet
and so there are some small rounding errors when rounded to
the nearest 1,000.

Balance sheet at 31 December 20x7

Bush Williams Williams Group

USD'000 TDD' 000 Ex rate USD' 000 USD'
000

Property, plant and equipment 6,235 8,500 6.75 1,259 7,494

Cost of investment 405 0 0
Goodwill (Working 2) 0 0 103

Current assets 2,214 4,782 6.75 708 2,922

Total assets 8,854 13,282 1,968 10,519

Share capital 1,500 1,500 Below 125 1,500

Retained earnings 5,109 6,527 Below 183 5,688
Forex difference reserve
(balance) 0 0 69

Minority interest (Working 3) 0 0 238

Current liabilities 2,245 5,255 6.75 779 3,024

Total equity and liabilities 8,854 13,282 1,968 10,519

189
Income statement for year ended 31 December 20x7

Bush Williams Williams Group

USD'000 TDD' 000 Ex rate USD' 000 USD'000

Revenue 10,200 15,850 6.50 2,438 12,638

Cost of sales (6,520) (6,820) 6.50 (1,049) (7,569)
Gross profit 3,680 9,030 1,389 5,069
Operating expenses (2,750) (3,540) 6.50 (545) (3,295)
Impairment losses 0 0
Finance costs (120) (50) 6.50 (8) (128)
Dividend from subsidiary 118 0 0
Profit before tax 928 5,440 836 1,646
Tax (200) (1,200) 6.50 (185) (385)
Profit for the period 728 4,240 652 1,261

Attributable to:
Equity holders of the parent 1,131
Minority interests (20% x 652) 130

Statement of changes in equity for the year ended 31 December 20x7

Bush Williams
USD’000 TDD’000
Balance at 31 December 20x6 4,799 3,287
Profit for the period 1,410 4,240
Total gains recognised in the
period 1,410 4,240
Dividends paid (500) (1,000)
Balance at 31 December 20x7 5,709 6,527

(Working 1: Goodwill on acquisition)

Fair value of consideration paid USD 405,000

Fair value of net assets acquired, being:
Capital of Williams TDD 1,500,000
Reserves of W at acquisition TDD 1,460,000
Equity of W at acquisition TDD 2,960,000
At spot exchange rate of 8: USD 370,000
Group share 80% (USD
296,000)
Goodwill at acquisition USD 109,000

This is reported in USD, but a record maintained of its value in

the functional currency of the subsidiary at acquisition:

USD 109,000 x 8 = TDD 872,000.

Working 2: Carrying value of goodwill

TDD Rate USD

190
 At acquisition 1.1.x6 872,000 8.00 109,000
Impairment losses 20x6 0
Unrealised exchange gain
(balance) 0 15,571
At 31.12.x6 872,000 7.00 124,571
Impairment losses 20x7* (174,400) 6.75 (25,837)
Unrealised exchange gain
(balance) 0 4,614
At 31.12.x7 697,600 6.75 103,348

* As this is a one-off material expense arising on a specific date,

the year-end rate appears to show a more true and fair view
than translating at an average rate.

Working 3: Minority interest

Net assets of Williams as consolidated 1,189

(USD 1,968 – USD 779)
Minority share at 20% of above 237.8

Working 4: Retained earnings of Williams

TDD' 000 Rate USD'000

Post-acquisition profits 1,827 7.25 252
Dividends 20x6 0
Sub-total 1,827
Profit 20x7 4,240 6.50 652
Dividends 20x7 (1,000) 6.75 (148)
Total 5,067 756

Check: Pre-acquisition profit 1,460

Retained earnings in balance
sheet 6,527

Working 5: Group reserves USD'000

Bush (parent co) 5,109
Less: Goodwill impairments (26)
Add: 80% post-acquisition profit of Williams
(80% x 756) 605
Group reserves 5,688

DISPOSAL OF FOREIGN OPERATIONS (IAS 21,

PARAGRAPHS 48 – 49)

On disposal of a foreign operation, any cumulative exchange

difference in equity relating to that subsidiary is “recycled”
though the income statement and so reported in the income
statement as part of the gain or loss on derecognition of the
foreign operation in the group financial statements.

191
Interaction with deferred tax (IAS 12, paragraph 50)

Any gain or loss reported under IAS 12 but not allowed as a

deductible expense or assessed as taxable income is very likely
to be a temporary difference in accordance with IAS 12,
requiring full provision for deferred tax.

192
IAS 36 Impairment of Assets

The need for the standard

IAS 36 provides the generic rules for recognition of impairments

of assets. Prior to its introduction, there were widely differing
practices between companies on the recognition of impairments,
including:

• Whether only impairments that were seen as permanent

would be reported

• Whether impairments were reported in the income

statement or taken directly to equity until the impaired
asset was scrapped or sold

• The basis used for valuing assets in order to assess if

any impairment had taken place.

Scope of the standard

The standard applies to all companies reporting under IFRS.

There are a number of other standards that provide specific
rules for identifying and valuing impairment losses. Where
another standard provides specific rules then that standard
prevails over the generic rules of IAS 36. This means that IAS
36 does not apply to:
• inventories (IAS 2 Inventories)
• assets arising from construction contracts (IAS 11
Construction Contracts)
• deferred tax assets (IAS 12 Income Taxes)
• assets arising from employee benefits (IAS 19 Employee
Benefits)
• financial assets within the scope of IAS 39 Financial
Instruments: Recognition and Measurement
• investment property measured at fair value (IAS 40
Investment Property)
• biological assets related to agricultural activity that are
measured at fair value less estimated point-of-sale costs
(IAS 41 Agriculture)
• deferred acquisition costs and intangible assets, arising
from insurance contracts within the scope of IFRS 4
Insurance Contracts and
• non-current assets (or disposal groups) classified as held
for sale in accordance with IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations.

193
In practice, the most common use of IAS 36 is to identify
impairments in:

• Property, plant and machinery

• Intangible assets other than goodwill

• Purchased positive goodwill.

Overview of the standard’s requirements

The standard requires that companies should at least annually

review whether there has been any evidence that an asset is
impaired. An impairment loss is the amount by which the
carrying amount of an asset exceeds its recoverable amount.

Framework focus
The Framework describes an asset as a
resource controlled by an entity which is
expected to produce a flow of future
economic benefits. This is the basis of
the principle of determining recoverable
amount. If an asset’s carrying value is
greater than its recoverable amount
(which is the value of the expected future
inflow of benefits) then the excess over
the recoverable amount does not meet
the definition of an asset. This excess
must therefore be written off as an
expense immediately.

Recoverable amount

This is a critical concept in recognising impairments and then

accounting for them. The recoverable amount is the maximum
inflow of benefits that an entity can expect from having control of
an asset. Control will normally be achieved by having ownership
of an asset which therefore normally gives the entity the option
to sell the asset. The maximum benefit from owning any asset
is therefore:

Recoverable amount is the higher of:

194
 Value in use Net realisable value

The net present value of The proceeds that could be

the estimated net cash
flows earned by ongoing
use of the asset by its
current owner
expected from selling the
asset to an unconnected
third party, less the costs
necessarily incurred to
enable that sale.

This means that if it is apparent that net realisable value

exceeds the value in use, the rational thing is to dispose of the
asset. This means that assets should never be recorded at an
impaired value below net realisable value.

In reality, it is often impossible to identify the value in use of an

individual asset, since that individual asset may not generate an
income stream on its own. This difficulty is solved by the
concept of the cash generating unit.

Cash generating unit

A cash generating unit is the smallest identifiable group of

assets that generates cash inflows that are largely (but not
necessarily wholly) independent of the cash inflows from other
assets or groups of assets. A working definition of a cash
generating unit might be that it is the smallest group of assets
that together could form a business that could be a going
concern in their own right.

Cash generating units may not be bigger than the segments

used by the business to report its results under IAS 14 Segment
Reporting.

The purpose of dividing the company into cash generating units

is similar to the treatment of inventory under IAS 2; ie to prevent
unrealised gains in the value of one group of assets masking
realised losses in another.

Case study 36.1

Canteena Co operates in two business areas of the leisure

195
business, one of which has two operating divisions. A review
of the value of the property, plant and equipment of each of
these operating divisions reveals the following estimates for
values in use and net realisable values:

Value in use NRV

Gyms and health clubs division: $115,000 $105,000

Cinemas division North: $40,000 $35,000

Cinemas division South: $60,000 $67,000

Totals $215,000 $207,000

The current carrying values before considering impairments of

the assets in each division are:

Gyms and health clubs division: $82,000

Cinemas division North: $38,000

Cinemas division South: $80,000

Totals $200,000

The company’s policy is to revalue all its property, plant and

equipment where possible.

Required

State the accounting journals necessary to record the

revaluations of the property, plant and machinery of Canteena
Co assuming that:

• The company as a whole is considered to be a cash

generating unit as no division within Canteena is
capable of generating independent cash flows.

• The three divisions above are each considered to be a

cash generating unit.

Solution to case study 36.1

If the company is considered to be one cash generating unit only

then the comparison is:

196
Current carrying value: $200,000

Value in use: $215,000.

The increase in value will therefore be recorded as a net

unrealised gain of $15,000 by debiting non-current assets
$15,000 and crediting equity by the same amount.

If the company is analysed more accurately into its component

cash generating units, the picture becomes:

Recoverable Carrying
VIU NRV amount value

Gyms and health clubs 115,000 105,000 115,000 82,000

Cinemas North 40,000 35,000 40,000 38,000
Cinemas South 60,000 67,000 67,000 80,000

There is an unrealised gain in gyms and health clubs of $33,000,

an unrealised gain in cinemas North of $2,000 and an
impairment in the value of cinemas South of $13,000.

It is possible in both circumstances that cinemas South may be

sold as its net realisable value is greater than its value in use,
suggesting that that division has more worth to somebody else
than it does to Canteena Co. It may therefore be reclassified as
a disposal group and a current asset under IFRS 5.

In this situation, the impairment loss of $13,000 (being $80,000

less the net realisable value of $67,000) will be written off
immediately. This is even if Canteena Co intends to not dispose
of cinemas South, as no non-current asset or group of non-
current assets should be recorded at an impaired value below
net realisable value.

Recognition of impairments (IAS 36 para 12 – 17)

At a minimum any of the indicators below should be taken to

indicate that an asset or cash generating unit has been
impaired, thus triggering a full impairment review and valuation:

• The market value of the asset has declined significantly

more than expected in the period

• Likely obsolescence, eg through technological

redundancy

• Long-term change to interest rates reducing the asset’s

NRV (see below)

197
 • Evidence that the company as a whole is worth more on
a break-up basis than as a going concern, ie evidence of
internally generated negative goodwill

• Physical damage to the asset

• Major plans to restructure the business suggesting that

the asset is redundant to the company’s needs

• Worse than expected output from the asset compared to

when it was last valued.

This list is not exhaustive but gives indicators. Any indicator that
suggests that the full carrying value of the asset may not be
recovered by net income of at least as great a value should
trigger a full impairment valuation.

Estimating value in use

The value in use is estimated using anticipated cash flows,

discounted at an appropriate rate. Care should be taken to
ensure that the assumptions made about risk in the estimated
cash flows are not duplicated in the choice of discount rate. For
example, if the future cash flows are estimated using very
conservative assumptions, a discount rate far above a risk-free
discount rate is likely to be inappropriate since this would
double-count the effective write-down of the asset’s value.

Allocation of impairment losses and reversal of

impairments
An impairment loss, being the carrying amount of an asset less
its recoverable amount, is recognised immediately in profit or
loss. If the asset is revalued in accordance with another IAS/
IFRS (eg an item of property, plant and equipment in
accordance with IAS 16 Property, Plant and Equipment), the
impairment loss is treated as a revaluation decrease in
accordance with that other standard. An impairment loss for a
cash-generating unit is allocated to reduce the carrying amount
of the assets of the unit in the following order:

1. reduce the carrying amount of any goodwill allocated to

the cash-generating unit, and then
2. reduce the other assets of the unit pro rata on the basis
of the carrying amount of each asset.

An impairment loss on any asset other than goodwill recognised

in prior periods is reversed if there is a change in the estimates
used to determine the asset’s recoverable amount since the last
impairment loss was recognised. In this case, the carrying
amount of the asset is increased to its recoverable amount, but

198
not exceeding the carrying amount of the asset that would have
been determined had no impairment loss been recognised in
prior years.

Purchased goodwill
For the purpose of impairment testing, goodwill acquired in a
business combination is allocated to each of the cash-
generating units, or groups of cash-generating units, that are
expected to benefit from the synergies of the combination.

Goodwill impairment must not be reversed.

COMPREHENSIVE CASE STUDY 36.2

S has identified a division that produces a specific product as a
cash generating unit. The carrying value of the assets at 31
December 20x5 is shown below:

$m $m
Goodwill 100
Tangible assets:
Land and buildings 400
Plant and machinery 140
_____
540
_____
640
_____
A competitor has recently introduced a superior version of the
product to the market. S has to react to this competition by
funding improvements and dropping the price of the product.
Both of these reduce the margin on the product and the
management believe that this information is an indicator of
impairment.

The following additional information is relevant:

(i) Forecast cash inflows from the production of the product
are as follows:
Year ended 31 December:
$m
20x6 200
20x7 170
20x8 110

(ii) The directors believe that a pre tax return of 11% is

appropriate to the level of risk of the manufacture of this type of
product.
(iii) The land and buildings are carried at a valuation. Their
depreciated historical cost is $240 million at 31 December 20x5.

199
(iv) The net selling price of land and buildings is estimated at
$300 million and that of the plant and machinery at $68 million.

Required

Calculate the impairment loss that must be recognised at 31

December 20x5 and explain how this loss will be treated in the
financial statements for the year ended 31 December 20x5.

200
Suggested Solution to case study 36.2:
Cash generating unit

(i) Impairment loss

$m
Carrying amount before impairment loss 640
Recoverable amount (398)
____
Impairment loss 242
____

Recoverable amount is value in use as this is higher than fair value less costs to sell
(W2).

Workings

(1) Value in use:

Forecast cash flows discounted at 11%: $m

Year l (200 × 0.90) 180

Year 2 (170 × 0.81) 138
Year 3 (110 × 0.73) 80
____
398
____
(2) FV less costs to sell:

$m

Goodwill –
Land and buildings 300
Plant and equipment 68
____
368
____

Accounting for the impairment loss

The credit entry

The impairment loss must be allocated to the various non-

current assets in the following order: firstly, goodwill and then to
the other assets on a pro rata basis.

Before Impairment After

impairment loss impairment
$m $m $m
Goodwill 100 (100) –
Land and buildings 400 (100) (W) 300
Plant and machinery 140 (42) (W) 98

201
 ____ ____ ____
640 (242) 398
____ ____ ____
Working

The impairment loss of $242m is first allocated to the goodwill

($100m). This leaves $142m to be allocated to the other assets
on a pro-rata basis.

400
Loss on land and buildings = × $142m = $105m
540

If this amount was written off the carrying amount of the land
and buildings would be reduced to $295m (400–105). This is
less than the fair value less costs to sell of the land and
buildings. IAS 36 prohibits the reduction of the carrying amount
of an asset to below its fair value less costs to sell during the pro
rating exercise. This means that only $100m of the impairment
loss can be charged against the carrying amount of the asset.
The balance of $5m must be charged elsewhere, in this case to
the plant and machinery.

140
Loss on plant and machinery = × $142 = $37m +
540
$5m (see above) = $42m.

The debit entry

The basic rule is that the loss is charged to the income

statement. However where a loss relates to an asset that is
carried at a revalued amount it must be taken to the revaluation
reserve to the extent that it is covered by the surplus on that
asset.

The land and buildings have been revalued. The impairment

loss that relates to this asset is recognised in reserves until the
reserve is reduced to zero.

The depreciated historical cost of the freehold land and buildings

is $240 million. This implies that the revaluation surplus that
relates to these assets is $160m (400 – 240). This is greater
than the impairment loss that has been allocated to the assets
($105m). The whole of this amount can be taken to equity.

The remainder of the impairment loss ($137 million) must be

recognised in the income statement for the year. It must be
included within operating profit and may also need to be
disclosed as an exceptional item.

202
Suggested step-by-step approach to impairments

1. Identify major classes of tangible and intangible non-

current assets

2. Set a date each period for assessment of if each class

has suffered an impairment. Note that this does not have
to be the year-end date, but the date that each class of
assets is considered must be the same each year.

3. Allocate assets, including purchased goodwill, to cash

generating units if assets do not generate an income
stream in their own right.

4. Each period, formally assess if there are any internal or

external factors suggesting that an asset or cash
generating unit may be impaired. If there are no such
factors, it is unlikely that an impairment loss needs to be
recognised.

5. If there are impairment indicators, prepare (or update)

the value in use and net realisable value calculations to
determine the impaired value for the asset.

6. Write off any impairment loss to the income statement or

to equity and/ or income statement if the newly impaired
asset had previously been revalued upwards through
equity.

7. Review any assets or cash generating units that had

previously been impaired to assess if there can be any
reversal of past impairments. This reversal cannot be
shown for goodwill.

203
IAS 37: Provisions, contingent liabilities and
contingent assets

The need for the standard

Prior to the introduction of IAS 37, there was considerable

confusion over what a provision actually was and when it should
be recognised. There were also wide differences in the
techniques used to evaluate what size of provision should be
recorded, for example whether the most probable figure or the
worst case scenario figures should be used.

Much of the confusion arose from the application of prudence,

since prudence on its own would suggest that the worst case
scenario should always be recognised as a future outflow in the
financial statements.

Abuse of provisions

Provisions were widely seen to be abused by companies

wishing to smooth profits. In years when profits exceeded
expectations if there were no restriction on when provisions
could be recognised, it would be easy to recognise a provision,
thus establishing a liability and reducing reporting profit. This
provision could then be released in subsequent years when the
true profit was below expectations. This fails to give a true and
fair view of the true performance of the business.

There was also considerable inconsistency in the recognition of

provisions at the time of acquiring control of another business.
A common use of “creative accounting” was to recognise a
provision in the books of the acquired company at the time of
acquisition. This has the effect of increasing goodwill asset and
providing a provision that could be released to increase post-
acquisition group profit.

Requirements of the standard

The standard gives mandatory rules on a number of aspects

relating to provisions, being:

• Revised definitions of provisions, contingent liabilities

and contingent assets
• Initial recognition of provisions
• Methods for establishing initial value of provisions
• Discounting of long-term provisions
• Recognising changes in value of provisions
• Disclosure requirements to enable analysts to
understand how provisions have been determined.

204
Definitions (paragraph 10, IAS 37)

A provision is a liability of uncertain timing or amount.

A liability is a present obligation of the entity arising from past

events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic
benefits.

An obligating event is an event that creates a legal or

constructive obligation that results in an entity having no
realistic alternative to settling that obligation.

A legal obligation is an obligation that derives from:

(a) a contract (through its explicit or implicit terms);
(b) legislation; or
(c) other operation of law.

A constructive obligation is an obligation that derives from

an entity’s actions where:
(a) by an established pattern of past practice, published
policies or a sufficiently specific current statement, the
entity has indicated to other parties that it will accept
certain responsibilities; and
(b) as a result, the entity has created a valid expectation on
the part of those other parties that it will discharge those
responsibilities.

A contingent liability is:

(a) a possible obligation that arises from past events and
whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity;
or
(b) a present obligation that arises from past events but is
not recognised because:
(i) it is not probable that an outflow of resources
embodying economic benefits will be required to
settle the obligation; or
(ii) the amount of the obligation cannot be measured
with sufficient reliability .
A contingent asset is a possible asset that arises from past
events and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity.

205
Contingent assets

Although the definition above uses the word “possible”, the

implementation guidance of IAS 37 uses the word “probable”,
meaning greater than 50% estimated probability.

An asset whose recovery is virtually certain such as an

insurance claim that is beyond dispute where the insurer is both
willing and able to pay is not subject to a contingency at all and
so is outside the scope of IAS 37. It would be recognised and
valued in the balance sheet as a normal asset.

An asset where a right to recover is probable but not certain is a

contingent asset. It is disclosed in the notes to the accounts but
not recognised with any value in the balance sheet.

Note that this is different to assets such as debtors, where the

legal right to recover is offset by an allowance for doubtful debts.
The right to recover is clear and so the debtor is recognised. A
contingent asset is one where its existence itself is questionable.
Contingent assets are common in the realm of insurance
recoveries for losses, where there may be a legal dispute
between insurance company and the person insured whether
the claim itself is covered by the terms of the insurance policy.

Contingent liabilities

A contingent liability as either a liability where an obligating

event might exist but the probability of an obligation to pay is
below 50%. It may also be the rare situation where an obligating
event exists, but the amount known is completely impossible to
estimate.

All contingent liabilities must be disclosed in the financial

statements, but not recognised in the balance sheet. For
example, where one company gives a guarantee over the
borrowings of another, this would be disclosed as a contingent
liability in the financial statements of the company giving the
promise.

Provisions

The definition of provision effectively prohibits recognition of

provisions for future outflows arising as a result of a future
intention, since an intention is not an obligation as it is possible
for the company’s management to change their mind. This is a
major change from previous common practice. Similarly,
provisions for future expected operating losses are prohibited.
However likely or difficult to avoid such losses might be, there is
no obligation to make losses if profitable opportunities arise.
There is therefore no liability.

206
If a business has an obligation to transfer an uncertain amount
of resources out of the business at some point in future, a
provision must be recognised. If there is only an intention rather
than an irreversible obligation a provision must not be recorded.
Initial recognition of provision

As soon as a company has an obligation, provision must be

recognised. The value to be recorded is the expected value of
the amount to be transferred. This amount will be an estimate
and it is highly likely that the eventual amount paid will be
materially different to the amount initially estimated when
provision is first made.

Distinguishing between provision and contingent liability

Provisions must be recognised in the balance sheet, with a likely

impact on profit. Contingent liabilities are not recognised in the
financial statements themselves, but rather are disclosed in the
notes to the financial statements. There are extensive
disclosure requirements for provisions.

Step by step approach to recognition of provisions and

contingent liabilities

The diagram below gives a practical step by step approach to

recognising provisions as against recognising contingent
liabilities:

207
A probable outflow is one where there is estimated to be a
greater than 50% probability that an outflow will occur.

IAS 37 does not define what is remote. In practice, it is a matter

of judgement taking into account the possible consequences of
the contingent liability. For example, any contingent liability that
could affect the gong concern status of the company should be
disclosed. A contingent liability with an estimated 10%
probability of an outflow of resources that is only just material
probably does not need to be disclosed.

Methods for establishing initial value of provisions

This provides some practical difficulty since estimating the

amount of the provision will rely on a probability model and an
average expected value. This is an area that is highly
judgemental and very difficult to audit given its inherent
subjectivity.

Discounting of long-term provisions

Where an outflow is expected and provision is therefore made,

an assessment must then be made of the likely timing of this
outflow. If the amount is expected to be paid some years from

208
the balance sheet date, the time value of money is likely to be
material.

IAS 37 requires that provisions must be discounted at a pre-tax

discount rate that reflects the current market assessments of the
time value of money and the risks specific to the liability. In
practice, this often means the required return that investors
would need to invest in that project (considering that higher risk
projects generally require a higher return than lower risk
projects).

Choice of discount rate

IAS 37 leaves a great deal of judgement in which discount rate

should be selected to find a rate that the risks attaching to the
type of liability to be discounted. In practice, a company should
choose a methodology for finding an appropriate discount rate
and then apply it consistently.

In practice, it is often best to select a discount rate that is easily

verified by external enquiry. For example, discounting long-term
liabilities by reference to the real yield on US government bonds
would provide a prudent measure of the provision’s value. It is
also common in practice to select fairly low discount rates. This
also has a practical advantage that many short- and medium-
term liabilities are likely to have an immaterial difference
between the discounted and undiscounted values. This
immateriality means that many liabilities can be presented at
their undiscounted value whilst still materially complying with IAS
37.

Illustration: Extract from the accounting policy note of

BP

The group makes full provision for the future cost of

decommissioning oil and natural gas production facilities and
related pipelines on a discounted basis on the installation of
those facilities. At 31 December 2005, the provision for the
costs of decommissioning these production facilities and
pipelines at the end of their economic lives was $6,450
million (2004 $5,572 million and 2003 $4,720 million). The
provision has been estimated using existing technology, at
current prices and discounted using a real discount rate of
2.0% (2004 2.0% and 2003 2.5%) …..To the extent that
these liabilities are not expected to be settled within the next
three years, the provisions are discounted using either a
nominal discount rate of 4.5% (2004 4.5% and 2003 4.5%) or
a real discount rate of 2.0% (2004 2.0% and 2003 2.5%), as
appropriate.

209
Case study 37.1
A company builds a nuclear power station in one year during
2000 at a cost of $1,250 million. It is expected to have a useful
life of 65 years, after which it will be de-commissioned. There
is some chance that the decommissioning will only occur in
2100 or 2110 however as it may be necessary to leave the
station unused for some years before it can safely be
decommissioned. The expected costs of decommissioning in
today’s money are $300 million. The power station started to
produce energy that could be sold at the end of 2000.
The company is required to set up a fund that will be used to
pay the decommissioning costs. In order to ensure that there
is only minimal chance of there not being sufficient funds to
pay for the decommissioning, this fund is held in US
government bonds, which have shown a yield of 5% before
inflation. Inflation in the country concerned is running at an
average of 3% pa.

The company uses a straight line method of depreciation for

the nuclear power station over 65 years.

Required:

Calculate the investment on 1 January 2000 that would be

necessary to yield the $300 million expected to be needed for
decommissioning if the decommissioning takes place in 2065.

Suggest an accounting treatment for these transactions and

draft extracts from the balance sheet and income statement:

• in the year 2000

• in the year 2001

• assuming that everything turns out as expected, in the

year when the decommissioning takes place (year
2065).

210
Solution

The investments are expected to produce a pre-tax real return

each year of 2%. The amount required to produce the
necessary $300 million in 65 years is therefore:

$300 million x 1 = $82.82 million

1.0265

If this were invested at 1.1.2000 then it would be expected to

yield enough assets to pay the liability, ie the outflow expected
no sooner than 65 years from the date of completion of the
power station.

If liabilities were not presented at their present value, the

balance sheet would show the following:

Assets 82,815
Liabilities (300,000)
Net liability (217,185)

This would not give a true and fair view, since there are
expected to be sufficient assets to pay the liabilities as the
outflows are demanded.

Long-term liabilities (including provisions) are therefore

discounted at an appropriate discount rate, where the time value
of money is material.

Instead, the liability is presented at its discounted value,

showing:

Assets 82,815
Liabilities (82,815)
Net liability 0

Over time, this discounted figure must be amortised up to the

actual expected outflow of $300 million. Long-term liabilities are
therefore initially discounted on their initial recognition and then
compounded back up to the actual cash flow. This
compounding back up is often referred to as the “unwinding” of
the initial discount.

The liability is recognised when construction starts, as:

Cr Provisions 82,815

Normally, recognition of a provision causes a debit to be taken

to expenses. This is since the transaction that gives rise to the
need for a provision normally only benefits the current period. In
this case however, taking an expense of $82,815 to the income
statement in 2000 would be totally misleading, since the
expected cost of decommissioning is expected to give benefits
to the company for the next 65 years.

211
The debit side is therefore added to the recognised value of the
non-current asset and depreciated over the 65 year expected life
of the asset.

So the initial recognition of the provision is

Dr Non-current assets $82,815

Cr Provisions $82,815

This means that the nuclear power station is initially recognised

with a total value of $1,332.815m ($1,250m + $82.815m). It
produces an annual depreciation charge of $20.5 million
($1,332.815m/65).

In the year to 31.12.00, there will be a year of depreciation, plus

a year’s charge to compound up the liability, as this was
recognised at 1 January 2001.

$ millions 2001 2000

Depreciation 20.5 20.5
Interest expense 1.66 (w1) 1.69 (w2)

(w1) $82.815m x 2% = $1.66m

(w2) ($82.815 m + $1.66m) x 2%.

Recognising changes in estimates of provisions

Each balance sheet date, each provision should be reviewed

and recalculated. The provision will change due to three
separate effects:

• Being one period closer to the expected outflow of cash

or other resources
• Changes in the underlying estimate of how much cash
will be expended
• Changes in the appropriate discount rate.

IAS 37 gives specific guidance on the effect of the first two of

these effects but is silent on the third. The notes before
therefore reflect what appears to be current best practice in
addition to the disclosure requirements of the standard.

Case study 37.2

During the year to 31 December 20x0, a company makes

212
accidentally leaks some oil into the environment, causing
considerable environmental damage and damage to the local
community. At 31 December 20x0, the company estimates
that it will pay $25 million to settle the cost of the damage,
including estimated legal fees of $4 million. It is expected
that this will be paid on 31 December 20x9. The company
has an insurance policy that it believes covers such an event
to a maximum recovery of $10 million, although the
insurance company claim that the company’s own negligence
means that it does not have to pay up on the insurance
policy.

At 31 December 20x1, the amount expected to be paid has

increased to $28 million.

The company wishes at 31 December 20x0 to set aside

funds to pay the expected liability. The company invests in
low risk government bonds that yield a real return of 3%. By
31 December 20x1, the long-term expected yield on such
bonds has risen to 3.25%.

Required

Show the effect of establishing the provision in the financial

statements at 31 December 20x0 and the effect of the
change in the provision in the financial statements in the year
to 31 December 20x1.

Solution

The potential recovery is not virtually certain. It is therefore a

contingent asset. Its existence will be disclosed in the notes to
the accounts if the company believes that its recovery is
probable (ie greater than 50% probability) but it must not be
netted against the provision assuming no recovery.

The investments are expected to produce a pre-tax real return

each year of 3%. The amount required to produce the
necessary $25 million in 9 years is therefore:

$25 million x 1 = $19.160 million

1.039

This is a result of activities in the current year with no purchase of a non-current

asset. The full effect of establishing the provision is therefore shown as an
expense in the income statement in the year to 31 December 20x0.

So the initial recognition of the provision is

Dr Operating expenses $19.160 million

Cr Provisions $19,160 million

213
The following year, the estimates have changed. The liability is also one year
closer to settlement. The year-end value of the provision has therefore changed
due to three factors:

• The effluxion of time

• A change in the appropriate discount rate
• A change in the underlying estimates of cash outflow.

IAS 37 requires that the 31 December 20x1 financial statements recognise the
most up-to-date estimate of the present value of the provision. As provisions are a
highly judgemental item in the financial statements that can be used to smooth
profits, IAS 37 requires clear disclosure of the effects of each of these changes.
This allows analysts to see which companies appear to change estimates
frequently, which implies profit smoothing.

If the estimates had remained the same, then there would be an increase in the
provision due to the passage of one year requiring an unwinding of the discount:

Dr Finance cost $19.160 million x 3% = $575,000

Cr Provision $575,000.

If the amount of the outflow and its timing remained the same but the discount rate
changed, then the provision required at 31 December 20x1 would be:

$25 million x 1 = $19.356 million

1.030258

However, the amount of cash outflow has also increased. This means that the
provision required in the balance sheet at 31 December 20x1 is:

$28 million x 1 = $21.679 million

1.030258

The provision’s history in double entry terms can therefore be shown as:

Provision for cost of environmental damage

31.12.x0 Expenses 19,160
31.12.x0 Carried down 19,160

19,160 19,160

1.1.x1 Brought down 19,160

Carried down
31.12.x1 (subtotal) 19,735 31.12.x1 Interest @ 3% 575

19,735 19,735

31.12.x1 C/d provision @ 3.25% 19,356 31.12.x1 Brought down 19,735

31.12.x1 Income statement 379

19,735 19,735

214
 C/d provision using all
31.12.x1 new estimates 21,679 31.12.x1 Brought down 19,356
Operating
31.12.x1 expenses 2,323

21,679 21,679

1.1.x2 Brought down 21,679

Disclosures

To facilitate a clear understanding of what a company is using provisions for, IAS

37 requires extensive disclosure of the existence of provisions, the uncertainties
surrounding the provision and movements on the provision in the year.

215
For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to
existing provisions;
(c) amounts used (ie incurred and charged against the provision)
during the period ;
(d) unused amounts reversed during the period ; and
(e) the increase during the period in the discounted amount arising
from the passage of time and the effect of any change in the
discount rate.
Comparative information is not required.

An entity shall disclose the following for each class of provision:

(a) a brief description of the nature of the obligation and the
expected timing of any resulting outflows of economic benefits;
(b) an indication of the uncertainties about the amount or timing of
those outflows. Where necessary to provide adequate
information, an entity shall disclose the major assumptions made
concerning future events,
(c) the amount of any expected reimbursement, stating the amount
of any asset that has been recognised for that expected
reimbursement.

Unless the possibility of any outflow in settlement is remote, an entity

shall disclose for each class of contingent liability at the balance sheet
date a brief description of the nature of the contingent liability and,
where practicable:
(a) an estimate of its financial effect;
(b) an indication of the uncertainties relating to the amount or timing
of any outflow; and
(c) the possibility of any reimbursement.

Case study 37.3

World Wide Nuclear Fuels, a company listed on a recognised stock

exchange, disclosed the following information in its financial
statements for the year ending 30 November 2005:

Provisions and long-term commitments

216
 (i) Provision for decommissioning the group’s radioactive
facilities is made over their useful life and covers complete
demolition of the facility within fifty years of it being taken
out of service together with any associated waste disposal.
The provision is based on future prices and is discounted
using a current market rate of interest.

Provision for decommissioning costs $m

Balance at 1 December 2004 675

Adjustment arising from change in price levels
(charged to reserves) 33
Charged in the year to income statement 125
Adjustment due to change in knowledge
(charged to reserves) 27
____
Balance at 30 November 2005 860
____

There are still decommissioning costs of $1,231m (undiscounted) to

be provided for in respect of the group’s radioactive facilities as the
company’s policy is to build up the required provision over the life of
the facility.

The company purchased an oil company during the year. As part of

the sale agreement, oil has to be supplied to the company’s former
holding company at an uneconomic rate for a period of five years. As
a result a provision for future operating losses has been set up of
$135m, which relates solely to the uneconomic supply of oil.
Additionally the oil company is exposed to environmental liabilities
arising out of its past obligations, principally in respect of soil and
ground water restoration costs, although currently there is no legal
obligation to carry out the work. Liabilities for environmental costs are
provided for when the group determines a formal plan of action on the
closure of an inactive site.

It has been decided to provide for $120m in respect of the

environmental liability on the acquisition of the oil company. World
Wide Nuclear Fuels has a reputation for ensuring the preservation of
the environment in its business activities.

Required

Discuss whether the provisions have been accounted for correctly

under IAS 37.

Suggested solution:

Decommissioning costs

IAS 37 has a significant impact on decommissioning activities. It

appears that the company is building up the required provision over
the useful life of the radioactive facility, often called the “units of
production method”. However IAS 37 requires the provision to be the
best estimate of the expenditure required to settle the obligation at the

217
balance sheet date. The provision should be capitalised as an asset if
the expenditure provides access to future economic benefits. If this is
not the case, then the provision should be charged immediately to the
income statement. IAS 37 does not prescribe the accounting
treatment for the resulting debit but amendments have been made to
IAS 16 “Property, Plant and Equipment” to ensure a smooth
interaction between the two standards. The asset so created will be
written off over the life of the facility subject to the usual impairment
test in IAS 36 “Impairment of Assets”. Thus the decommissioning
costs of $1,231m (undiscounted) not yet provided for will have to be
brought onto the balance sheet at its discounted amount and a
corresponding asset created.
The current practice adopted by the company as regards the
discounting of the provision is inconsistent. The provision is based on
future cash flows but the discount rate is based upon current market
rates of interest. IAS 37 suggests that the discount rate should be a
pre-tax rate that reflects current market assessments of the time value
of money and the risks specific to the liability. The discount rate
should not reflect risks for which future cash flow estimates have been
adjusted. Therefore, the provision should be based on current prices
discounted by the current market rate.

The company currently makes a reserve adjustment for changes in

price levels. However this adjustment would have two elements, the
unwinding of the discount which should be charged to the income
statement, and treated as a financing cost, and changes in cash flow
caused by a change in the discount rate. There was no clear
consensus on how to treat this change and therefore the IASB issued
IFRIC 1Changes in Existing Decommissioning and Similar Liabilities,
the consensus of this interpretation being that any changes in cash
flow caused by a change in discount rate should be adjusted against
the carrying value of the relevant asset.

The amount charged to reserves of $27m, in respect of change in

knowledge, should not be charged to reserves. If the change in
knowledge is in respect of the original estimate for the
decommissioning costs then it could be argued that this is a change in
the estimate and the new amount should be recognised as part of the
cost of the asset. Again IFRIC 1 clarifies this point and requires that
any change to the original estimate should be made against the
carrying value of the asset.

Oil company
One of the quite explicit rules of IAS 37 is that no provision should be
made for future operating losses. However, if the company has
entered into an onerous contract then a provision will be required. An
onerous contract is one entered into with another party under which
the unavoidable costs of fulfilling the contract exceed the revenues to
be received and where the entity would have to pay compensation to
the other party if the contract was not fulfilled. Thus it appears that
the contract should be loss making by nature. Thus in this case the
provision of $135m would remain in the financial statements and
would affect the fair value exercise and the computation of goodwill.

218
Provisions for environmental liabilities should be recognised when the
entity becomes obliged (legally or constructively) to rectify
environmental damage or perform restorative work on the
environment. A provision should only be made where the company
has no real option but to carry out remedial work. The mere existence
of environmental contamination caused by the company’s activities
does not in itself give rise to an obligation. Thus in this case there is
no current obligation.

However it can be argued that there is a “constructive obligation” to

provide for the remedial work because the conduct of the company
has created a valid expectation that the company will clean up the
environment. Thus there is no easy solution to the problem as it will
be determined by the subjective assessment of the directors and
auditors as to whether there is a “constructive obligation”. It is a
difficult concept and one which will result in different interpretations.

Suggested step-by-step approach to provisions and contingent

liabilities

1. Determine an accounting policy and apply it consistently, eg a

policy never to discount provisions where the outflow is
expected within three years of the balance sheet date.

2. Identify any possible obligating events at the balance sheet

date

3. Work through the summary flowchart above to determine if

each possible obligating event requires a provision or is a
contingent liability.

4. Where an obligating event requires a provision, estimate pre-

tax cash flows in today’s money and the timing of these cash
flows.

5. Calculate the closing provision required as an undiscounted

figure

6. Discount this provision at an appropriate rate if its settlement is

not within the short-term

7. Calculate any changes in opening provision in this order:

8. Compound discounted opening provisions at the rate used to

discount them: show this as a finance cost in the income
statement

9. If there is a change in the appropriate discount rate,

recalculate the new provision using the latest discount rate.
Show any further difference as an income statement expense

10. Recalculate each provision required using the latest estimates

of cash outflow, timing of outflow and latest discount rate.
Show any final difference as an operating expense.

219
11. State the accounting policy, discount rates used and any
reason for movement on provisions as a note to the financial
statements.

220
IAS 38: Intangible Assets

Scope
IAS 38 prescribes the accounting treatment for intangible assets,
except:

• intangible assets that are within the scope of another

Standard. For example, IAS 2 Inventories applies to
intangible assets held for sale in the ordinary course of
business;
• mineral rights and expenditure on exploration for, or
development and extraction of non-regenerative
resources.

The need for the standard

The Framework defines an asset as an asset resource

controlled by an entity which is reasonably expected to produce
an inflow of benefits. In the past, a number of companies have
attempted to increase the perceived strength of the balance
sheet and also simultaneously increase the profit figure by
treating certain expenses as deferred costs.

The standard is focused on establishing consistent criteria for

recognition of intangible assets, for dealing with their write-off
over time and for establishing when it is possible to revalue
intangible assets.

Initial recognition of intangible assets

Intangible assets may be acquired by an entity in a number of

different ways:

• By being purchased individually, or

• By being developed internally by the entity itself, or

• By being purchased as part of a new business

combination, either as an intangible asset in the books
of the new subsidiary or as goodwill on the new business
combination.

221
 Framework focus

The Framework paragraphs 82 – 83 describe

the process of recognition of any element of
financial statements, with paragraph 83 giving
the criteria for recognition. Recognition is the
process of including an asset in the balance
sheet with an appropriate monetary value and
description.

The recognition criteria for all elements (including assets) under

IFRS are the cornerstone of accounting for intangible assets, since
a fundamental issue with many intangible assets is whether they
can even fairly be said to exist! The recognition criteria in the
Framework are:

An item that meets the definition of an element should be

recognised if:

• It is probable that any future economic benefit associated

with the item will flow to or from the entity, and

• The item has a cost or value that can be measured with

reliability.

An asset under IFRS is a resource controlled by an entity as a

result of past events which is expected to produce an inflow of
future benefit to the entity controlling it.

Step-by-step approach to recognition of intangible assets

The process of enquiry for whether an intangible asset can be

recognised is therefore to ask:

• Is it controlled by the reporting entity?

• Is there reasonable certainty that it will generate an

inflow of benefits for the reporting entity?

• Can it be given a cost or a reliable fair value?

• Should the intangible be recognised as an intangible in

its own right or simply as part of goodwill?

If the answer to any of these questions is no, then no intangible

asset may be recognised. If its acquisition has involved
spending some cash or other resource, this outflow must be
treated as an expense.

222
Case studies 38.1 – 38.7

Consider the above step-by-step approach to determine if the

items below must be recognised as intangible assets under IAS
38, or if instead they must be recognised as an expense.

38.1 Expenditure on research leading to a prototype

38.2 Development costs improving the performance of a

product that is already on the market

38.3 Costs of providing training in IFRS to staff

38.4 Market research costs

38.5 The good name earned by a company over many years of

trading, where it is estimated that the company’s brand
earns $8 million more a year in profit than if the company
did not have that brand

38.6 The publishing title of a national newspaper

38.7 The value of a company’s customer list and marketing

mailshot database
Suggested solutions to case studies 38.1 – 38.7:

38.1 38.2 38.3 38.4 38.5 38.6 38.7

Is it controlled by
Yes Yes Yes Yes Yes Yes Yes
the reporting
entity?

Is there
reasonable No Maybe No, No Probably Yes Probably
certainty that it will staff not
generate an inflow can
of benefits for the leave
reporting entity?
Can it be given a
N/A Yes N/A N/A Maybe No Probably
cost or a reliable
not
fair value?

Should the
intangible be N/A Yes N/A N/A Part of Part of Part of
recognised as an goodwill internally internal
intangible in its generated goodwill
own right or simply goodwill
as part of
goodwill?

A separately
recognised No Maybe No No No No No
intangible non-

223
current asset?

Internally generated goodwill, brands, mastheads, publishing

titles, customer lists and similar items are not recognised as
assets, since there is insufficient certainty whether they will
generate an inflow of benefits and/ or they have no identifiable
(ie marginal) cost.

Expenditure on research is recognised as an expense. There is

no recognition of an intangible asset arising from research as its
stream of benefits is insufficiently certain to meet the Framework
definition of an asset.

An intangible asset arising from development is recognised only

if specified criteria are met. If an intangible item des not meet the
criteria for recognition as an asset, the expenditure is recognised
as an expense when incurred. Expenditure that was initially
recognised as an expense is not included in the cost of an
intangible asset at a later date.

The initially recognised value is the marginal cost of acquiring

the asset. Internal expenses such as apportionment of general
overhead that would have been incurred regardless of the
acquisition of the intangible asset may not be capitalised.

Goodwill or not goodwill?

On a new business combination, the acquirer is likely to have

paid a premium for control of the acquired business and its
future income stream. This is purchased positive goodwill,
which is capitalised and tested for annual impairment under
IFRS 3.

Frequently, acquirers prefer to identify other intangible assets of

the acquired company which can be recognised separately from
goodwill, as goodwill is seen by many analysts as not being a
“real” asset and so it is less likely to increase a company’s share
price than a patent for example.

This does not necessarily have any impact on profit, as

intangible assets and goodwill eventually are expensed to the
income statement via either annual impairment testing or by
systematic amortisation.

The distinction between goodwill and other intangible assets

depends on whether the other assets are separable from
goodwill. To be separable from goodwill, it must be possible to
sell the intangible asset without substantially disposing of the
newly acquired business. In some cases, a group of intangible
assets may not be separable from each other, but as a group
they may be separated from the business without threatening
the going concern status of the business. An example of this

224
would be if a soft drinks manufacturer makes a number of drinks
including a brand called “Caribbean Spring”. The intangible
asset of the right to extract water and the brand name may be
recognised separately from goodwill but not from each other,
since one relies on the other for its ability to generate profit.

IAS 38 distinguishes between brands and trademarks. A brand

is seen as being similar to the trade name of the company itself
and thus not separable from goodwill. Trade marks are more
akin to sub-brands and could be sold separately without selling
the company as a whole. It is possible to capitalise trademarks
separately from goodwill but not brands. (Paragraph 37, IAS
38).

Impairments, amortisation and revaluation

Subsequent to initial recognition, an intangible asset is carried

at:

• cost, less any accumulated amortisation and any

accumulated impairment losses; or

• revalued amount, less any subsequent accumulated

amortisation and any accumulated impairment losses.
The revalued amount is fair value at the date of
revaluation and is determined by reference to an active
market.

An intangible asset may only be carried at a subsequently

revalued amount if there is an active market for the asset.
Paragraph 8 of IAS 38 defines an active market as a market
where:

• The items traded in the market are homogenous, and

• Willing buyers and sellers can be found at any time, and

• Prices are available to the public

Case study 38.8

Discuss whether there is an active market for the following

intangible assets:

• International football players (eg David Beckham’s

transfer to LA Galaxy

• Carbon credits to pollute under the Kyoto Protocol

proposals (assume that the Protocol had been fully
enacted).

225
Solution to case study 38.8:

There is no active market, as the asset in question is by its

nature unique. Although there may be an active market for
footballer transfers, there is no active market for individual
footballers until they are actually sold. So the value of David
Beckham cannot be used to reliably value another footballer,
such as Wayne Rooney. Footballers can only be recognised at
the amortised value of what was paid to acquire them; there
can be no subsequent upwards valuation because other
footballers have been transferred for large sums.

Carbon credits under the Kyoto Protocol could have been

traded, in the same manner that other regulatory quotas such
as agricultural production quotas are traded. One carbon credit
is much the same as another, so a recent transaction to buy
and sell a carbon credit can be used as a reliable valuation of
another, identical, carbon credit. There is thus an active
market in homogenous assets.

Any revaluation increase is credited directly to equity as

revaluation surplus, unless it reverses a revaluation decrease of
the same asset previously recognised in profit or loss. Any
revaluation decrease is recognised in profit or loss.

However, the decrease is debited directly to the revaluation

surplus in equity to the extent of any credit balance in
revaluation surplus in respect of that asset.

An entity assesses whether the useful life of an intangible asset

is finite or indefinite; the useful life is indefinite if there is no
foreseeable limit to the period over which the asset is expected
to generate net cash flows. The depreciable amount of an
intangible asset with a finite life is amortised on a systematic
basis over its useful life. An intangible asset with an indefinite
useful life is not amortised, but is tested for impairment at least
annually.

Impairment of intangible assets is recognised in accordance with

IAS 36 Impairment of Assets.

The gain or loss on derecognition of an intangible asset is the

difference between the net disposal proceeds, if any, and the
carrying amount of the item. The gain or loss is recognised in
profit or loss.

Comprehensive case study 38.9

226
On 1 July 20x4 Heywood, a company listed on a recognised
stock exchange, was finally successful in acquiring the entire
share capital of Fast Trak. The terms of the bid by Heywood
had been improved several times as rival bidders also made
offers for Fast Trak. The terms of the initial bid by Heywood
were:

• 20 million $1 ordinary shares in Heywood. Each share

had a stock market price of $3·50 immediately prior to
the bid;

• a cash element of $15 million.

The final bid that was eventually accepted on 1 July 20x4 by

Fast Trak’s shareholders. Heywood had improved the cash offer
to $25million and included a redeemable loan note of a further
$25 million that will be redeemed on 30 June 2008. It carried no
interest, but market rates for this type of loan note were 13% per
annum. There was no increase in the number of shares offered
but at the date of acceptance the price of Heywood’s shares on
the stock market had risen to $4·00 each.

The present value of $1 receivable in a future period where

interest rates are 13% can be taken as:

at end of year three $0·70

at end of year four $0·60

The fair value of Fast Trak’s net assets, other than its intangible
long-term assets, was assessed by Heywood to be $64million.
This value had not changed significantly throughout the bidding
process. The details of Fast Trak’s intangible assets acquired
were:

(i) The brand name of “Kleenwash” a dish washing

liquid. A rival brand name thought to be of a similar
reputation and value to “Kleenwash” had recently
been acquired for a disclosed figure of $12 million.
(Paragraph 40, IAS 38)

(ii) A government licence to extract a radioactive ore

from a mine for the next ten years. The licence is
difficult to value as there was no fee payable for it.
However, as Fast Trak is the only company that can
mine the ore, the directors of Heywood have
estimated the licence to be worth $9 million. The
mine itself has been included as part of Fast Trak’s
property, plant and equipment.

(iii) A fishing quota of 10,000 tonnes per annum in

territorial waters. A specialist company called
Quotasales actively trades in these and other quotas.
The price per tonne of these fishing quotas at the
date of acquisition was $1,600. The quota is for an
indefinite period of time, but in order to preserve fish

227
 stocks the government has the right to vary the
weight of fish that may be caught under a quota. The
weights of quotas are reviewed annually.

Suggested Solution
Fast Trak
$m $m
Net tangible assets 64
Intangible assets – fishing quota 16
– brand 12
– goodwill 28 56
__ ___
Net assets/purchase consideration 120
___
Notes:
Purchase consideration:
shares 20 million @ $4 80
cash 25
loan note 25 million @ 0·60 15
___
120
___

IFRS 3 Business Combination requires intangible assets

acquired as part of a business combination to be recognised
separately from goodwill. The standard requires that any
intangible that is capable of separate recognition and whose fair
value is identifiable at the date of acquisition will be recognised
as a separate asset and not subsumed within the value of
goodwill.

Kleenwash

A brand, almost by definition, is unique; however IAS 38 says

that where similar assets have been bought recently this may be
used as a basis for determining a “reliable” value.

Government licence

As there was no fee payable for this licence, Fast Trak could not
carry it at a value other than zero. The licence may well be
classed as a separate asset but it can only be used in
conjunction with the mine and cannot be sold on to other parties.
This does not necessarily mean that it would have a zero value
in Heywood’s consolidated balance sheet. However, the
problem is that there is clearly not an active market in these
licences (there is only one) and there is no information of how
the directors of Heywood arrived at the figure of $9 million given
in the question. If this is the discounted future cash flows
attributable to the licence this may constitute a reliable measure
of cost. However, given the circumstances, such cash flows

228
could not be solely attributed to the licence as they involve the
use of other assets. Thus, it is likely that the licence could not
be separately recognised.

Fishing quota

This appears to satisfy the definition of an active market,

therefore the fair value is 10,000 × $1,600 = $16 million. The
quota may well be classed as an intangible asset with an
indefinite life as the quota is for an indefinite period of time. If
this were the case the quota would be capitalised and tested
annually for impairment, the quota would not be amortised. If
Heywood followed the revaluation model for subsequent
measurement then if the price per tonne were to increase above
$1,600 the asset would be revalued with any increase in value
being taken direct to equity.

If the government were to impose a finite life upon the quota

then from that point in time the asset would have a finite life and
would be amortised over the life of the quota imposed by the
government.

Goodwill

This is the excess of the purchase consideration over the net

tangible and separate intangible assets.

The remainder of the long-term intangible assets is attributable

to the goodwill of Fast Trak.

229
IAS 40 Investment Property

The need for the standard

Investment properties potentially fall into the category of

financial investments (which would be covered by IAS 39) and
property, which would be covered by IAS 16. This potential
confusion over definition and accounting treatment therefore
necessitates a separate accounting standard.

Definition (IAS 40, paragraph 5)

Investment property is property (land or a building or part of a

building or both) held (by the owner or by the lessee under a
finance lease) to earn rentals or for capital appreciation or both,
rather than for:

• Use in the production or supply of cgoods or services or

for administrative purposes, or

• Sale in the ordinary course of business.

It is also possible for a lessee holding property under an

operating lease to classify that building as investment property,
so long as the operating lease is instead treated as a finance
lease and the investment property is kept at its fair value in the
investor’s balance sheet. This is a recent change to IAS 40,
which deals with the practical situation that it is common for
leases of land and buildings to be long enough to allow for a
probable investment return but which do not substantially
transfer the risks and rewards incident to ownership. For
example, a lease over some land of 50 years may be enough to
make a profit on future assignment of the lease over the land,
but the infinite life of land makes it difficult to fit a lease of land
into IAS 17’s definition of a finance lease.
If a property is partly owner-occupied and partly let out as an
investment property, the portions should be treated separately if
they can be sold separately, if not it is treated under IAS 16
rules, unless only an insignificant portion is owner occupied.

Where a property is let to a parent or other subsidiary, then in

the consolidated financial statements it is treated as an owner-
occupied property under IAS 16, but in the individual financial
statements of the lessor it is treated as an investment property
under this Standard.

Initial recognition

As with assets generally, investment property is recognised in

the financial statements from the moment when it meets the
definition of an asset (ie when it becomes probable that there

230
will be a future inflow of benefits) and when it can be measured
reliably. Investment property is initially recognised at cost. This
cost includes transaction costs of acquiring the property.

If an investment property has been built by the entity itself, it is

recognised as a deferred cost under IAS 16 until the time when
it is complete and able to generate a rental yield. Upon
completion, it is reclassified as an investment property under
IAS 40.

The cost of constructing an investment property cannot include

any abnormally high costs of construction, start-up costs nor
operating losses incurred until the property reaches its full level
of occupancy.

Framework focus
These rules for non-recognition of
abnormally high costs of construction are
consistent with the Framework’s definition
of an asset since these losses are
unlikely to generate a stream of benefit
into the future.

Investment properties held under leases are initially recognised

at the lower of the present value of the lease obligation and the
property’s fair value, in accordance with finance lease
accounting under IAS 17.

Transfers to, or from, the investment property classification are

made only when there is evidence of a change in use.

Subsequent valuations

Subsequent to initial recognition, investment property is carried

using either the cost model or the fair value model:

Choice of accounting policy

Cost model Fair value model

Cost, less accumulated Fair value is the price at

depreciation and any
accumulated impairment
losses, as prescribed by
IAS
which the property could be
exchanged between
knowledgeable, willing
parties in an arm’s length
transaction.

Consistency requires that the same policy should be applied to

all investment properties. A change from one method to another
should only be made where it will result in a more appropriate

231
presentation. The Standard envisages that a change from fair
value to cost is unlikely to be appropriate. This suggests that
the fair value model is the preferred accounting treatment for
investment property under IFRS.

Cost Model

An enterprise choosing the cost model should adopt the

benchmark treatment in IAS 16 (as referred to above). Note: the
allowed alternative in IAS 16 (of revaluation reported as reserve
movements) is not permitted for investment properties. It can
however, be used for non-investment properties.

Where the cost model is chosen, the fair values of the

investment properties must be disclosed in the notes to the
accounts in addition to the cost model figures in the balance
sheet.

The measurement model is applied consistently to all investment

property. However, an entity may choose either the fair value
model or the cost model for investment property backing
liabilities that pay a return linked directly to the fair value of
specified assets including that investment property, regardless
of the model chosen for all other investment property.

Fair Value Model

An enterprise that chooses the fair value model should, after

initial recognition, value all its investment properties at their fair
values.

A gain or loss arising from a change in the fair value of an

investment property should be included in the net profit or loss of
the period in which it arises.

Note: this differs markedly from revaluations in IAS 16, which

are generally treated as movements on an unrealised
revaluation reserve. IAS 40 effectively treats movements in fair
values as realised. The introduction to the Standard makes it
clear that the IASB prefer the fair value model, but they also
recognise that this is a controversial issue about which many
accountants have reservations, and this is why, for the time
being, the cost model is permitted.

The fair value of an investment property is usually its market

value. The market value is preferably determined by an
independent valuer experienced in the type of property and local

232
market. It is based on an arm’s length transaction ie between
independent unrelated parties on commercial terms. The market
value is based on an informed willing buyer and an informed
willing seller in an open market under normal selling conditions
(eg after proper marketing of the property). Circumstances
unique to a buyer or seller should be ignored (eg where a seller
may be in financial difficulties and requires a ‘quick’ sale or it is a
‘forced’ sale.)

Although current prices on an active market of similar properties

represents the best evidence of fair values, other sources of
information can provide evidence of fair values if there is an
insufficient volume of recent similar property sales to give an
objective fair value. These other sources include:

• prices for dissimilar properties adjusted to reflect

differences;

• prices on a less active market adjusted to reflect

economic changes since those prices occurred; or

• discounted estimated future net cash flows relating to

existing leases. This would only be appropriate where
there is external evidence that they are similar properties
in the same location and condition and the rentals are at
current levels.

Fair values should not ‘double count’ certain assets. For

example, fair values determined from rentals for a furnished
letting would include the value of the furniture, which should not
then be recognised again as a separate asset. In the rare cases
where it is not possible to reliably determine a fair value on a
continuing basis for an individual property it should be treated
under the benchmark treatment in IAS 16 (at cost less
depreciation and impairments). When adopting the fair value
model this only applies to the individual property, all other
investment properties should be measured at fair value.

Derecogition of investment property

The gain or loss on derecognition of an item of investment

property is the difference between the net disposal proceeds, if
any, and the carrying amount of the item. This is consistent with
the general principle that the gain or loss on derecognition of
anything is the difference between the new item coming into the
balance sheet (eg sales proceeds) and the item leaving the
balance sheet (eg an investment property held at fair value). The
gain or loss is included in profit or loss.

Obviously a disposal will occur if a property is sold, but it would

also be considered as ‘sold’ where it is let under a finance lease.

233
The gain or loss on disposal is the difference between the
carrying value and the net sale proceeds (discounting should
apply to deferred consideration) and it is recognised as income
or expense in the income statement. Special rules contained in
IAS 17, Leases apply to sales and leasebacks.

Transfers under the cost model

Where the cost model has been adopted, all transfers between
classifications are made at the carrying value (historical cost
less depreciation and impairments) of the property, no gains or
losses will arise. This treatment is uncontroversial and presents
no difficulties.

Transfers under the fair value model

Transfers from investment properties should only occur where

there is a change of use. This may be because an owner
decides to occupy a property that was previously used as an
investment property or there may be an intention to dispose of
the property. Normally, in the latter case, an enterprise would
continue to show the property as an investment property until it
is sold. However, where it is intended to develop the property
before it is sold, it should be transferred to inventory. For both of
the above transfers the ‘cost’ of the property for the purpose of
the transfer is the fair value at the date of the transfer.

An owner occupied property appropriately transferred to

investment properties at the end of the owner occupation should
be revalued to its fair value at the date of transfer. Any
difference between its carrying value and fair value should be
treated as a revaluation under IAS 16 (normally a reserve
movement). Where a property that has been included in
inventory (because it is available for sale) and is then let on an
operating lease to a third party it should be transferred to
investment properties at its fair value at the date of the transfer.
Any gain or loss on its carrying value immediately before the
transfer is included in the profit or loss for the period. This is
consistent with the treatment of profits on the sale of inventories.

An investment property in the course of (self) construction or

development is treated under IAS 16 as property, plant and
equipment. When construction is complete it is transferred to
investment properties at its fair vale at the date of completion.
Any difference between the fair value and the carrying value of
the property is recognised in income in the period of the transfer.

Case study 40.1

Speculator owns a number of properties. An independent surveyor has

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assessed their market values as:
Valuation Valuation
Property Cost 1 July 20x3 30 June 20x4 30 June 20x5
$ $ $
A 41,000 52,000 73,000
B 76,000 82,000 66,000
C 80,000 70,000 90,000
197,000 204,000 229,000
All the properties had an estimated life of 50 year when they were
acquired. They are all let on short leases under commercial terms,
however property C is let to a fellow subsidiary of Speculator. The
group policy (applied by all members of the group) is to adopt the fair
value model in IAS 40 for investment properties and to treat owner-
occupied properties under the benchmark treatment in IAS 16.

Required:
Prepare extracts of the group financial statements of Speculator in
respect of the above properties for the years to 30 June 20x4 and
20x5.
How would this differ if the question asked for the entity statements of
Speculator?

Solution:
In the consolidated financial statements property C would have to be
classified as an owner-occupied property and treated under IAS 16 .
This means it would be carried at deprecated historic cost.

Income statement: - year to 30 June 20x4 20x5

$ $
Depreciation – property C ($80,000/50 years) (1,600) (1,600)
Investment property surpluses - A 11,000 21,000
-B 6,000
Investment property deficits - B (16,000)
Balance sheet: as at 30 June 20x4 20x5
Property, plant and equipment – C 78,400 76,800
Investment properties 134,000 139,000
In the entity financial statements of Speculator property C would be
classed as an investment property. The property would not be
depreciated. Instead a deficit of $10,000 in 20x4 and a surplus of
$20,000 in 20x5 would be reported as well as the above surpluses and
deficits on properties A and B.

Disclosure (in addition to that in IAS 17, Leases)

An enterprise should disclose:

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 • the method of determining fair values. It should state that
this was by reference to market values, or, if not, the
other factors in determining the value should be
disclosed;

• that a qualified independent valuer with appropriate

experience has valued the investment properties, or, if
not, this fact should be disclosed;

• the amounts in the income statement for:

– rental income from investment properties;
– their direct operating expenses split between those
properties that generated income and those that did not.

• any restrictions on the realisability of investment

properties or on the remittance of rental income;

• contractual obligations to purchase, construct or develop

investment properties.

Fair value Model

• a detailed reconciliation (similar to property, plant and

equipment under IAS 16) of the carrying value of
investment properties at the beginning and end of the
period;

• net gains or losses from changes in fair values;

• net exchange gains or losses on the translation of the

financial statements of a foreign entity (presumably
relating to investment properties held by a subsidiary);

• transfers to and from inventories and owner-occupied

properties.

Where the fair value of an individual property cannot be reliably

measured, the above reconciliation should be disclosed
separately for that property. There should be a description of the
property, the reasons why its fair value cannot be measured
reliably and, if possible, a range of fair values for it. Details of the
gains or losses on the disposal of such properties should also be
separately disclosed.

Cost Model

Similar disclosures are required to those that apply to properties

classified as property, plant and equipment under IAS 16:

• deprecation methods and rates, useful lives etc;

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• a detailed reconciliation of the carrying value of investment
properties at the beginning and end of the period;

• impairment losses;

• exchange gains and losses;

• transfers to and from inventories and owner-occupied

properties; and

• the fair values of the properties.

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